AGGREGATE DEMAND

WHAT IS AGGREGATE DEMAND?

Aggregate demand is the total demand for final goods and services at a given time and price level.

It gives the amounts of goods and services that will be demanded at all possible price levels. In

other words this is the demand for the gross domestic product of a country

 The aggregate demand curve (AD) describes the total volume of aggregate expenditures in the

economy at different price levels

COMPONENTS OF AGGREGATE DEMAND

AD = C + I + G + (X-M)

(a) PRIVATE  It comprises a household’s expenditure on the

(HOUSEHOLD) consumption of goods and services.
CONSUMPTION  These goods can be durable, semi-durable or non-
EXPENDITURE (C ) durable.
 Consumption of households depends upon their
Disposable Income & MPC.

(b) INVESTMENT  It refers to the expenditure incurred by firms on the

EXPENDITURE ( I ) purchase of capital goods like machines, plant, equipment, etc. to
increase the production capacity.
 Investment decision depends upon the relative values of
MEI (Rate of Return) & Rate of Interest.

(c) GOVERNMENT  It refers to expenditure incurred by the government on

EXPENDITURE (G) the purchase of consumer goods and capital goods to satisfy the
collective wants of the society. For example– Public parks,
Public hospitals, Roads, etc.
  Government expenditure depends upon the priorities of
the government.

(d) NET EXPORTS  It is the difference between exports and imports.

(X-M)  It reflects the net demand for a domestic product by rest
of the world.
 Net exports depend upon many things like Foreign
Trade Policy, Foreign Exchange Rate, Comparative Prices &
Quality, etc.

THE AGGREGATE DEMAND (AD) CURVE

The aggregate demand curve is plotted with real output on the horizontal axis and the price level

on the vertical axis. The aggregate demand curve, AD, like the demand curves for individual

goods, is downward sloping, implying that there is an inverse relationship between the price level

and the quantity demanded of real GDP.

WHY THE AGGREAGATE DEMAND CURVE IS

DOWNWARD SLOPING?

 The Price Level and Consumption: The Wealth Effect

  The Price Level and investment: The interest Rate Effect

 The Price Level and Net Exports: The Net export Effect

1. The Wealth Effect

The aggregate demand curve is drawn under the assumption that the government holds the supply

of money constant. One can think of the supply of money as representing the economy's wealth at

any moment in time. As the price level rises, the wealth of the economy, as measured by the

supply of money, declines in value because the purchasing power of money falls. As buyers

become poorer, they reduce their purchases of all goods and services. On the other hand, as the

price level falls, the purchasing power of money rises. Buyers become wealthier and are able to

purchase more goods and services than before. The wealth effect, therefore, provides one reason

for the inverse relationship between the price level and real GDP that is reflected in the

downward-sloping demand curve.

 A decrease in the price level makes consumers feel wealthier, which in turn encourages them to

spend more.

 This increase in consumer spending means larger quantities of goods and services demanded.

The wealth effect occurs because certain financial assets have returns stated in nominal dollars.

If the price level rises unexpectedly, the real return on these assets falls.
1. The Interest Effect

As the price level rises, households and firms require more money to handle their transactions.

However, the supply of money is fixed. The increased demand for a fixed supply of money causes

the price of money, the interest rate, to rise. As the interest rate rises, spending that is sensitive to

rate of interest will decline. Hence, the interest rate effect provides another reason for the inverse

relationship between the price level and the demand for real GDP.

 A lower price level reduces the interest rate, which encourages greater spending on investment

goods.

 This increase in investment spending means a larger quantity of goods and services demanded

2. The Net export Effect

As the domestic price level rises, foreign-made goods become relatively cheaper so that the

demand for imports increases. However, the rise in the domestic price level also means that

domestic-made goods are relatively more expensive to foreign buyers so that the demand for

exports decreases. When exports decrease and imports increase, net exports (exports imports)

decrease. Because net exports are a component of real GDP, the demand for real GDP declines as

net exports decline.

Movement Along vs. Shift of Aggregate Demand Curve

Movement Along AD Curve Shift of Aggregate Demand Curve

 A change in the level of Aggregate  A change in any factor other than a

Demand that is caused by a change in the change in the price level that changes the
 price level is referred to as a movement level of Aggregate Demand results in a shift

along the Aggregate Demand curve. of the Aggregate Demand curve

 The figure titled "Movement along  The figure titled "Shift of Aggregate

AD Curve" illustrates a movement from Demand Curve" illustrates a rightward shift.

point A to point B.  Factors that Shift the Aggregate

 As the price level rises, consumption Demand curve include changes in

and net exports decline because of the wealth autonomous consumption, investment,

and international trade effects, respectively. government expenditures and net exports

The economy moves along the Aggregate

Demand curve.

BUSINESS CYCLE

INTRODUCTION

The term Business cycle refers to economy –wide fluctuations in production, trade, and general

economic activity. The Business cycle is the upward and downward movements of levels of Gross

domestic product and refers to the period of expansions and contractions in the level of economic

activities around a long term growth trend.

PHASES OF THE BUSINESS CYCLE

 Expansion/Growth:

During this phase of the business cycle, consumer and business spending rise. Unemployment will drop

during this phase, which will further aid consumer spending.

 Peak:

After a period of growth, an economy will reach a peak, where business is producing at or near full

capacity, and the economy is at or near full employment.

 Recession:

This is a phase when real GDP begins to decline. Consumers and business reduce their spending,

unemployment rises, investment declines, and pessimism about the economy is likely to grow.

 Trough/Depression:

This is the lowest point of the business cycle. Factories will be operating below capacity, allowing

unemployment to reach high levels. Jobs are difficult to find in this phase, and many businesses may fail.

CAUSES OF BUSINESS CYCLES

 Internal Factors:

1. Consumption: When consumer spending increases, businesses will increase production- causing

them to hire more workers and purchase more materials and capital goods. When consumer spending

decreases, the opposite will occur.

2. Business investment: The purchasing of capital goods increases the number of jobs in the

economy because people have to make those goods. If investments increases, the economy will grow, if

investment decreases, the economy will contract.

3. Government activity: The government can influence the business cycle through fiscal policy

(its tax and spend policies) and monetary policy (its control of the money supply, largely through the

Federal Reserve).

 External factors

1. Inventions and innovation: Major changes in technology can influence the business cycle.

Usually technological changes move the economy in a positive direction, but this is not always so.

2. Wars and political events: The impact of such events on the economy are very fact specific-

in other words, difficult to generalize about.

Trough/Depression

In this situation the level of income and Employment Falls. The aggregate demand for goods and

services decreases. As a result, the prices of goods and services fall .The profit of the producers

decreases.

Expansion/Growth

The depression does not last forever. Economy gradually converts itself gradually Aggregate

demand for good increases and which then start income in prices  and the recovery time period
start here producer get little bit profit into rival the consumer increases expenditure when the

prices do not fall further  recovery emerges and price level, wages, interest rate, rate of profit,

employment and production all start rising gradually.

Peak

At this point the Aggregate demand increases for everything. In the period of Revival when

profit increases the firms get loans from the banks. In this way the rate of interest increases. But

the economy crosses the level of full-employment inflation is generated. As a result process and

cost increases during the Boom. The price level, consumption, expenditures, income of people,

wages, profit, employment and output reach the highest level.

 Recession

The boom does not last forever. The banks had advanced loans excessively. The firm who have

produced a lot have to be sold at decreased prices. Due to losses the aggregate demand for labor

decreases. Moreover the wages are also a problem for the producers. So, in a result great losses

to the producer being disappointed, there is a big cut in the output and Employment. The

recessionary trends develop in the economy and economy reaches where from started.