Aggregate Demand

Aggregate Demand :

           

            Aggregate demand is a schedule or curve that shows the amount of real output (real GDP) that buyers collectively desire to purchase at each possible price level. The relationship between the price level (as measured by the GDP price index) and the amount of real GDP demanded is inverse or negative. Which means, when price level rises, the quantity of real GDP demanded decreases; when the price level falls, the quantity of real GDP demanded increases.

As for the reason why the demand curve is download sloping; it is due to several reasons explained below:

1. Real wealth effect

A decrease in price level would increase the consumers’ spending on goods and services. Therefore, the real value of money, measured by the quantity of goods and services each dollar buys, rises. 

           

            ↓P  → ↑purchasing power → ↑W/P  →  ↑C  →  ↑AE ( increase in real GDP. )

2. Interest-rate effect/money demand effect

A reduction in the price level will reduce the need of consumers to borrow money in order to purchase goods and services. A reduction in demand for borrowings would reduce the level of interest rate, hence reducing the cost of borrowing. This will lead to a rising investment as it will increase the AE. 

 ↓P  →  ↑purchasing power  →  ↓demand for credit  →  ↓i  →  ↑investment (I)   →  ↑AE ( rise in real GDP. )

3. Foreign purchase effect

            A reduction in the price level would mean that our goods and services are relatively cheaper than the imported items, which would eventually reduce the value of imports.  A reduction in the price level would also mean that foreigners are attracted to our goods, increasing the level of our exports.  Consequently, the net export will rise, bringing rise to the level of AE.   

            ↓P  →  ↓M (our goods cheaper than abroad) + ↑X (foreigners buy our goods) →  ↑AE ( rise in real GDP. )

Next, there are four determinants of aggregate demand. The changes in aggregate demand involve two components. First, a change in one of the determinants of aggregate demand that directly, changes the amount of real GDP demanded. While for the other one, a multiplier effect that produces a huge change in aggregate demand.

Four determinants that changes the aggregate demand:

•         Consumer Spending/Expenditure (C)

•         Investment Expenditure (I)

•         Government purchases (G) and

•         Net exports

Now let’s have a look at the first determinant which is the consumer spending/expenditure. Under the consumer spending/ expenditure determinant, there are several factors that cause the shift in aggregate demand curve. Those factors are consumer wealth, consumer expectations, household debt, and taxes.

·         Consumer wealth – Consumer wealth is the total dollar value of all assets owned by consumers in the economy less the dollar value of their liabilities, known as debts.

·         Consumer expectation – Changes in consumer expectation about the future may change the pattern of consumer spending.

·         Household debt – Consumers can increase their consumption spending by borrowing, it would shift the aggregate demand to the right.

·         Taxes – Reduction in personal taxes would lead to less spending by consumers.

Next, under the investment-spending determinant, there are several factors that cause the shift in aggregate demand curve. Those factors include real interest rate and expected returns.

·         Real interest rate - Interest rates affect the firm because they represent a cost of business projects.

·         Expected returns - Expectation about future sales.  If firms expect sales to increase in the future, they will invest to meet this expected increase in demand. 

Under unexpected returns, it is influenced by several factors:

·         Future business condition – Optimistic future of business conditions, firms are likely to forecast a higher return on current investment or may make more investment.

·         Technology – New and improved technologies enhance the rate of returns on investment as well.

·         Degree in excess capacity – Increase in excess capacity, known as unused capital would reduce rate of returns.

·         Business taxes – An increase in business taxes will reduce profit after tax there leading to a lower rate of returns.

Lastly, under the government spending determinant, there are several factors that cause the shift in aggregate demand curve. Those factors include net export spending.

Under net export spending, it is influenced by two possibilities to change the net export spending.

·         National Income Abroad – The increasing national income abroad encourages foreigners to buy more products from our home country.

·         Exchange rates - Exchange rate is the price of one currency expressed in another currency.  An appreciation of RM means that RM has increased in price, making foreign goods cheaper. 

Increases in AD: Above-Full Employment and Demand-Pull Inflation.

            One type of inflation would be the demand-pull inflation. Due to the rising demand for Malaysia goods and services by households and firms, there will be a shortage of goods and services in the short run. Therefore, firms will be able to push the prices of goods and services up. Moreover, due to the high demand, firms will now produce more goods and services and since consumers are willing to pay high price, firms will raise the prices of goods and services.

            The factors which cause total aggregate demand to increase would be an increase in consumer spending, government spending, investment spending as well as export earnings. An increase in income level or consumer confidence will lead to an increase in consumption spending, thus, increasing the aggregate demand. For example, a rise in disposable income in Malaysia will result in Malaysian consumers being able to buy more goods and services than previously. This will cause the demand for goods and services to increase, indicating a rise in consumption spending as well as in the prices of goods and services.

            The following diagram shows the rise in the price level from P1 to P2, the increase in aggregate demand ; AD1 to AD2 beyond the full-employment level of output causes inflation. The increase in demand expands real output from the full-employment level Qf to Q1. The distance between Q1 and Qf is a positive, or ‘ inflationary ‘, GDP gap.