Download Chapter 40: Aggregate demand (2.2)

Chapter 40: Aggregate demand (2.2)
Key concepts
• Simple demand vs aggregate demand (AD)
• Components of AD
• Why the AD curve is downward sloping
The AD curve
The components of
AD
•
Distinguish between the microeconomic concept of demand for a
product and the macroeconomic concept of aggregate demand
•
Construct an aggregate demand curve
•
Explain why the AD curve has a negative slope
•
Describe consumption, investment, government spending and net
exports as the components of aggregate demand
‘It’s the economy stupid!’ Campaign slogan for Bill Clinton dreamt up by his advisor James Carville.
•
Simple demand vs aggregate demand (AD)
Let us point out a few basic similarities to the simple demand curve in order for you to have something to
hook your learning curve on to – all the while keeping in mind that aggregate supply and demand models
are far more complex since we are dealing with all goods and services rather than a single good.
1) Just as in simple demand (demand for a single product) aggregate demand curve is downwardsloping, which shows negative correlation between the price level (measured by the GDP
deflator) and real output (measured by real GDP). This is quite similar to the simple supply and
demand model. However, note that it is impossible to use ‘quantity’ on the X-axis when dealing
with the aggregate since there is a slight difference between paper clips, nuclear submarines and
deep sea oil rigs. To overcome this, we use the inflation-adjusted monetary value of aggregate
output, e.g. real GDP.
2) The pattern of correlation shows that a fall in the average price level (GDP deflator) will lead to a
movement along the aggregate demand curve – i.e. an increase in real GDP at a given price level.
Didn’t we just forget something?
3) Yes, that all other influences on aggregate demand are assumed to be held constant, i.e. ceteris
paribus. Once again our model is based on the concept that the pattern of correlation will hold
true only if all other variables are left unchanged. (See Shifting the aggregate demand curve
following.)
•
Components of AD
Aggregate demand is the sum of total planned expenditure for a given price level by households, firms,
government and foreign sector during a period of time. The components of aggregate demand have been
covered in Chapter 37 in the expenditure method of GDP accounting:
•
Consumption expenditure (C in the formula below); households’ spending on goods and services
•
Investment expenditure (I); firms’ expenditure on capital goods such as machines and factories –
this is an addition to the capital stock of the economy (do NOT confuse investment with
“…buying shares…” – this is in fact a form of saving)
o
Gross investment is when firms increase spending on capital goods due to an increase in
demand for their goods
o
Net investment occurs when firms replace worn out capital (also known as replacement
investment)
•
Government spending (G); government spending goes to health care, defence, roads…etc. It is
assumed to be unlinked (“exogenous” in econ-speak) to the price level, e.g. determined by
political decisions at local, regional and national level.
•
Export revenue (X); spending on domestic goods by foreign firms, households and governments
•
Import expenditure (-M); expenditure on foreign goods by domestic firms, households and firms
(note that this component must be deducted since foreign goods and services are not part of GDP)
Aggregate demand is the sum of expenditure components, which gives us:
AD = C + I + G + X – M
It is worthwhile noting at this early stage the italicised ‘planned’. In the previous circular flow model all
expenditure was de facto (= actual, realised) GDP, since all output also represented expenditure and income
– it would be impossible for expenditure to exceed output. In the aggregate demand/supply model we
attempt to show a more dynamic and realistic view of the macroeconomic world by showing what happens
when planned expenditure increases at a different pace than de facto output, e.g. inflation is brought into
the picture.
The aggregate demand in an economy is dependent on a great many influences, which is to say that the
individual components of aggregate demand are influenced by a great array of underlying variables. And
similar to the previous case of (simple) supply and demand, a model is built to show the relationship
between price and quantity – yet since we are dealing with all goods and all prices we have to expand the
model a bit.
•
Why the AD curve is downward sloping
Figure 3.3.1 shows the relationship between aggregate demand and the average price level. The AD curve
shows the connection between the price level and real GDP. The GDP deflator puts the price level into
constant (real) prices (here, 1995) and the four points, A, B, C and D, show how the quantity demanded of
real GDP increases as the price level falls. If we were still dealing with simple demand, say video films or
bicycles, we would explain this by saying that there is an income effect (lower prices mean that people have
more spending power) and a substitution effect (people change consumption habits and switch to other
goods). Both of these effects are in fact present in the downward slope of the aggregate demand curve but
there is a greater level of complexity when dealing with the aggregate.
The AD curve shows the relationship between
the price level (measured by the GDP deflator)
and real GDP (constant values). The AD curve
is downward sloping for three reasons:
A
D
A
+
130
(C
Real income effect; when the price level
falls, real income rises
2.
Real balance effect; a fall in the price
level means that the opportunity cost of
saving increases, so households and
firms lower saving levels and increase
expenditure
3.
International substitution effect; lower
prices – ceteris paribus – will increase
exports and decrease imports
+
120
1.
G
B
I+
X
110
)
M
C
–
Price level (GDP deflator 1995 = 100)
Figure: 3.3.1 The basic aggregate demand model
D
100
80
85
90
95
GDPreal /t (billions 1995 EUROs)
(Type 4 Smaller heading) Why the aggregate demand curve slopes downward
It is most important to keep in mind that in drawing the curve we are assuming ceteris paribus, so only the
price level changes; other macro variables such as interest rates, income for trade partners, domestic
incomes, inflation…etc remain the same. The income and substitution effects from the simple demand
model are discernable in the three main reasons for a downward sloping aggregate demand curve:
1.
Real income effect: A fall in the general price level means that real income has increased, assuming,
as we are, that all else remains the same. In this case, we are assuming that the amount of money
flowing around the system – the nominal quantity of money has not changed and neither have wages
– therefore people will increase their planned expenditure and quantity demanded of real GDP will
rise. Referring to figure 3.3.1, if the price level goes from 130 to 120, the quantity demanded of real
output will increase from €80 billion to €85 billion; this would move us along the aggregate demand
curve from point A to point B.
The aggregate demand/supply model is based on real output which means that GDP is based on real
values of money in terms of purchasing power. A fall in the price level means that the purchasing
power of any given quantity of money increases, resulting in a de facto increase in real incomes. We
are in essence positing that the larger the amount of real money in the economy, the higher the
quantity of goods and services – real GDP – will be demanded.
In economic short-hand: ∆price level → ∆Yreal → ∆C → ∆QAD
2.
Real balance effect: Another way of looking at the downward slope of aggregate demand is that both
households and firms try to strike a balance between planned present and future
investment/consumption. Future investment/ consumption are to a large extent the savings of the
present. When households and firms save they are in fact putting off present expenditure to the
future. The balance between present expenditure and future expenditure is disrupted when the price
level changes, since lower price levels mean that firms’ and households’ savings are worth more in
real terms. (This is analogous (= similar) to the real income effect above.)
A fall in the price level means that firms and households can save less but still retain a satisfactory
level of future consumption/ investment. With less being saved, consumption and investment
expenditure rises, leading to a movement from A to B in figure 3.3.1. This is an example of the
inter-temporal substitution effect. Again, don’t be alarmed by the term ‘inter-temporal’. It simply
means between (‘inter-‘) times (‘temporal’) and deals with how households and firms might
substitute planned future consumption/ investment by bringing some of it to the present. Since the
opportunity cost of decreasing present saving has gone down – due to the fall in the price level and
the increase in real savings – firms and households will be able to increase consumption and
investment sooner rather than later.
In economic short-hand: ∆price level → ∆value real savings → ∆potential future C & I →
∆opportunity cost of present C & I → ∆C & I → ∆QAD
3.
International substitution effect: Two components of domestic aggregate demand deal with the
foreign sector, namely exports and imports. Assume an open economy and that the domestic price
level falls relative to trade partners’.1 Domestic firms and households will substitute some of their
expenditure on imported goods for domestic goods; import expenditure will decrease. (Since
imports are a minus value in aggregate demand, lower import expenditure will increase aggregate
demand.) Conversely, a lower price level – assuming ceteris paribus, i.e. the exchange rate and price
level in trading countries remains the same – will lead to increased quantity demanded from our
export sector. This means that net exports (X-M) increase, leading to an increase in quantity
demanded of real output; a movement from A to B in figure 3.3.1.
In economic short-hand:
∆domestic price level → ∆relative PM→ ∆↓Μ → ∆QAD
And: ∆domestic price level → ∆relative PX → ∆X→ ∆QAD
1
Inserting “relative” here is rather important. If our trade partners’ average prices increase by 5% and our
domestic prices increase by 3% then domestic prices have fallen relative to trade our trade partners’.
MACOECONOMIC MODELS: CONFUSING A CHANGE IN
PRICE LEVEL WITH A CHANGE IN INTEREST RATES
A strong influence in aggregate demand is the rate of interest, i.e. the ‘price’ one pays for
borrowing money – alternatively, the ‘return’ one receives for keeping money in the bank.
The interest rate is positively linked to the price level, i.e. when the price level goes up,
so do interest rates. This is because lenders (creditors, e.g. banks) will want to retain the real
rate of interest being paid to them by debtors (= borrowers, e.g firms and households), and
higher inflation means that banks will have to raise the interest demanded from households
and firms in order for future incoming interest flows to the bank to have at least the same
value in real money terms as when the loan was taken. Another reason is that when the
price level rises, firms and households will have to increase their borrowing (= demand for
loans increases) in order to retain consumption and investment levels – the interest rises (=
price of loans) rises.
So; ∆↑price level → ∆↑r (interest) and conversely; ∆↓price level → ∆↓r
Assume now the economy is at point A on the aggregate demand curve in figure 3.3.1 and
that the price level falls. This will lead to a fall in interest rates, as explained above.
The lower the interest rate, the lower the opportunity cost of consumption and investment
since households and firms forgo less interest on their savings. Households and firms will
now be inclined to increase their expenditure. Another way of looking at this is that since
the interest rate has fallen, expenditure on items funded by credit – firms’ expenditure on
capital and households’ purchases of durable goods such as cars and furniture – will
increase. There is a movement along the aggregate demand curve from point A to point B.
We get; ∆↓price level → ∆↓r → ∆↓S → ∆↑C & I → ∆↑QAD
Now, here’s the warning! In the example given, it is the price level that has changed –
which in turn affected interest rates and thus consumption and investment. This is an
increase in quantity demanded of real GDP, i.e. a movement along the aggregate demand
curve. However, as shall be seen in Section 3.4, an increase or decrease in interest rates will
cause, respectively, a decrease or increase in aggregate demand – that is to say, a shift in the
aggregate demand curve. Whether there is a movement along or shift in aggregate demand
depends on which variable has initially changed in the economy; a change in the price level
– ceteris paribus – leads to an increase in quantity demanded of real GDP. If interest rates
change for any other reason, say that the central bank lowers the rates, there will be a shift
in the aggregate demand curve.
In summa;
•
∆price level → ∆r → ∆C & I → ∆QAD = movement along AD curve
•
∆r → ∆C & I → ∆AD = shift of AD curve
POP QUIZ 3.3.1: AGGREGATE DEMAND
1.
Explain how the variables interest, inflation and consumption are inter-linked. Note that these
variables show dual-causality!
2.
Which component of aggregate demand is assumed to be independent of the price level? Explain
why.
3.
Why is it possible for a change in interest rates to be linked to both a movement along and shift of
the aggregate demand curve?
4.
How does the international substitution effect help create a downward sloping AD curve?
Summary and revision
1. Simple demand shows the ability and willingness of consumers to buy a single good.
The sum of total demand, the aggregate, shows the demand for all goods and services
in an economy.
2. Our AS-AD model uses the overall price level instead of “price” and total output
adjusted for inflation – real GDP – instead of “quantity”.
3. The AD shows the correlation between the overall price level (GDP deflator) and the
demand for consumption, investment, government and net export expenditure.
4. The AD curve is downward-sloping due to
a. The real income effect; a fall in the price level means that real incomes rise –
which leads to increased consumption, investment and net exports
b. The real balance effect; a fall in the price level means that the real value of
savings has increased and households can save less and spend more
c. The international substitution effect; a fall in the price level – ceteris paribus!
– means that the relative price of exports has fallen and the relative price of
imports have risen – export revenue increases and import spending decreases