Aggregate Demand and Supply

AGGREGATE DEMAND AND SUPPLY

AGGREGATE DEMAND:-

Aggregate demand is the amount which will be spent at different values of the price level. It is composed of consumption (C), investment (I), government spending (6) and net exports (X—M).

THE AGGREGATE DEMAND CURVE:-

The aggregate demand curve shows the quantity of goods and services which households, firms, overseas buyers and government are prepared to buy at different values of the general price level. It is drawn on the assumption that other things (e.g. the money supply, rates of taxation, the marginal propensity to consume) remain unchanged. Figure 28. I shows an aggregate demand curve.

WHY THE ADCURVE SLOPES DOWN FROM LEFT TO RIGHT:-

There are three main reasons why there is an inverse relationship between the general price level and aggregate demand and hence why the AD curve slopes down from left to right.

• A rise in the price level reduces the real value of people’s income and wealth and hence decreases their ability to consume.

• Higher prices increase people’s and firms’ demand to hold money for transactions purposes. This increase in the transactions demand for money is likely to raise the rate of interest and thereby reduce demand for consumer goods (consumption) and demand for capital goods (investment).

• An increase in the general price level will make domestic goods and services less competitive against foreign goods and services. This will reduce demand for domestic products from both domestic and foreign consumers.

MOVEMENTS ALONG THE DEMAND CURVE:-

As with a demand curve for a particular product, the cause of a movement along an aggregate demand curve will be a change in price, in this case a change in the general price level. A rise in the general price level will cause a contraction in aggregate demand and a fall in the general price level will cause an extension in aggregate demand. Figure 28.2 shows an extension in aggregate demand. If the general price level falls people’s purchasing power will increase, the transactions demand for money will fall causing a reduction in interest rates and domestic goods and services will become more price competitive.

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THE SHAPE OF THE AGGREGATE DEMAND CURVE:-

One group of economists, Keynesians, believe the aggregate demand curve is steep. This is because they think that a rise in the general price level will have only a small impact on the rate of interest and this in turn will have only a small impact on consumption and investment. They argue that the demand for money is dominated by the speculative rnotive. This is interest elastic so that an increase in demand for money will cause only a small rise in the rate of interest. In their view the main influence on both consumption and investment is income and not the rate of interest. The implication of the aggregate demand curve being steep is that a change in the general price level will not significantly alter aggregate demand.

In contrast new classical economists believe the aggregate demand curve is shallow, they think the main component of the demand for money is the transactions demand. This is interest inelastic so if a rise in the general price level leads to an increase in demand for money there may be a large rise in the rate of interest. Again, contrary to the Keynesian view, new classical economists believe a change in the rate of interest can have a significant impact on consumption and investment. So in their view, changes in the general price level can have a large effect on aggregate demand.

SHIFTS IN THE AGGREGATE DEMAND CURVE:-

The aggregate demand curve will shift to the right (an increase in aggregate demand) or shift to the left (a decrease in aggregate demand) if there is a change in an influence on aggregate demand other than a change in the general price level.

An increase in aggregate demand will cause more to be demanded at any given price level. An increase in aggregate demand is illustrated in Figure 28.3.

CAUSES OF SHIFTS IN AGGREGATE DEMAND:-

The aggregate demand curve will shift if households, firms, the government and/or foreigners alter the amount they wish to spend at any given price level. There are a number