Aggregate Demand

KLOs
• Aggregate demand (AD)
• Aggregate demand curve AO2, AO4
Diagram: AD curve

Components of AD: consumption (C) + investment (I) + government

spending (G) + net exports (total exports [X] - total imports [M]). AO2

Determinants of AD components. AO2

• C: consumer confidence, interest rates, wealth, income taxes, level of
household indebtedness, expectations of future price level
• I: interest rates, business confidence, technology, business taxes, level of
corporate indebtedness
• G: political and economic priorities
• X - M: income of trading partners, exchange rates, trade policies

Shifts of the AD curve caused by changes in determinants AO2,

AO4

Diagram: shifts of the AD curve

2.2 Aggregate Demand and Aggregate Supply
Introductio
n to AD

Introduction to Aggregate Demand

In microeconomics, the primary model used to show the interactions of buyers and sellers in
market was the supply and demand model. In macroeconomics, we will deal with total supply
and total demand. The model we will use to examine the interactions of ALL the buyers and ALL
the sellers in a nation’s economy is the aggregate demand and aggregate supply model.

Aggregate Demand: The total demand for the output of a nation at a range of price levels in a
particular period of time from all consumers, domestic and foreign.

Similarities between Aggregate Demand and Demand:

• The curve illustrating both slopes downwards, showing an inverse relationship between how much is demanded and
prices
• There are ‘non-price determinants’ of both demand and aggregate demand. Changes in these factor will cause the
curves to shift
• A decrease in both causes employment and output to fall. A fall in demand will cause output and employment in a
particular industry to decrease; a fall in aggregate demand will cause output and employment in an entire country to
decrease.
• An increase in both causes prices to rise. A rise in demand will cause the price of a particular good to increase; a rise in
aggregate demand causes the average price level in an entire nation to increase (inflation).
2.2 Aggregate Demand and Aggregate Supply
Aggregate
Demand

The Aggregate Demand Curve

The aggregate demand curve looks strikingly similar to a demand curve for a particular product.
Let’s examine the differences.
The Demand Curve The Aggregate
Demand Curve

Average Price level

Price

Aggregate
Deman
Demand
d
Quantity demanded Real Gross Domestic Product
(rGDP)
Notice the following:
• The AD curve shows the quantity demanded of the total output (GDP) of the nation’s economy while demand shows
just the quantity demanded for a particular good.
• The AD curve is plotted against the average price level in a nation, showing that at higher prices, less of a nation’s
output is demanded than at lower prices. Demand shows simply the relationship between the price of a particular
good and the quantity demanded of it.
 Meaning and Measurement of Aggregate Demand
• Aggregate Demand (AD) =
– Total level of planned real expenditure on the goods and
services produced within a country
• The components of aggregate demand are:
– Household spending on goods and services (C)
– Gross Fixed Capital Investment Spending (I)
– Value of the Change in Stocks (Inventories)
– Government Consumption (G) (Public services)
– Exports of Goods and Services (X)
– (minus) Imports of Goods and Services (M)
• GDP (expenditure-based) is the actual value of expenditure
• Changes in AD are key to understanding short-term
fluctuations in a cycle e.g. recession and recovery, boom and
slowdown
2.2 Aggregate Demand and Aggregate Supply
Aggregate
Demand

The Components of Aggregate Demand

A change in the average price level of a nation’s output will cause a movement along the AD
curve, but a change in other variable will cause the AD curve to shift in or out. The components
of aggregate demand are the four types of national expenditures introduced in the previous
presentation. These are: The Aggregate Demand Curve
• Household Consumption
• Capital Investment
• Government spending
• Net Exports

Average Price level

P1
Assume a nation’s economy begins at AD1:
• An increase in any of the four expenditures will
AD2
cause AD to shift out to AD2, leading to a higher
quantity of output demanded at P1. AD1
AD3
• A decrease in any of the expenditures will cause
Y3 Y1 Y2
AD to shift in to AD3, leading to a lower quantity
Real Gross Domestic Product (rGDP)
of output demanded at P1.
 The Aggregate Demand Curve (AD)

General
Price Level

GPL2 A rise in the price level causes a

contraction of AD

GPL1

GPL3
AD = C+I+G+
(X-M)

Y2 Y1 Y3 Real GDP
 The Aggregate Demand Curve (AD)

General
Price Level

GPL2 A rise in the price level causes a

contraction of AD

GPL1 A fall in the price level

causes an expansion of AD

GPL3
AD = C+I+G+
(X-M)

Y2 Y1 Y3 Real GDP
Understanding why the AD Curve Slopes Downwards

Falli • As the price level rises, the real value of income falls
ng and consumers are less able to buy what they want or
real need – this is known as the real balance effect
inco
mes

Bala • A persistent rise in the price of level of Country X

nce could make foreign-produced goods and services
of cheaper, causing a fall in exports and a rise in imports
trad
e
• If the price level rises, this causes inflation and an
Inter increase in demand for money and a possible rise in
est interest rates on loans which then has a deflationary
rate effect on consumer and business demand
effe
ct
2.2 Aggregate Demand and Aggregate Supply
Aggregate
Demand

Why does the AD Curve Slope Downwards?

The demand for a nation’s output is inversely related to the average price level of the natin’s
good. There are three explanations for this:
• The wealth effect: Higher price levels reduce the purchasing power or the real value of the nation's
households' wealth and savings. The public feels poorer at higher price levels, thus demand a lower
quantity of the nation's output when price levels are high. At lower price levels, people feel wealthier
and thus demand more of a nation's goods and services. (This is similar to the income effect which
explains the downward sloping demand curve).
• The interest rate effect: In response to a rise in the price level, banks will raise the interest rates on loans
to households and firms who wish to consume or invest. At higher interest rates the quantity demanded
of products and capital for which households and firms must borrow decreases, as borrowers find higher
interest rates less attractive. The opposite results from a fall in the price level and the decline in interest
rates, which makes borrowing more attractive and thus increases the quantity of output demanded.
• The net export effect: As the price level in a particular country falls, ceterus paribus, goods and services
produced in that country become more attractive to foreign consumers. Likewise, domestic consumers
find imports less attractive as they now appear relatively more expensive, so the net expenditures on
exports rises as price level falls. The opposite results from an increase in the price level, which makes
domestic output less attractive to foreigners and foreign products more attractive to domestic
consumers.
 Shifts in the Aggregate Demand Curve (AD)

AD1 – AD2: Outward

General shift – will raise national
Price Level output at all price levels

GPL1

AD3 AD1 AD2

Y1 Y2 Real GDP
 Shifts in the Aggregate Demand Curve (AD)

AD1 – AD2: Outward

General shift – will raise national
Price Level output at all price levels

AD1 – AD3: Inward shift

– will reduce national
output at all price levels

GPL1

AD3 AD1 AD2

Y3 Y1 Y2 Real GDP
 The Relative Importance of Components of AD
Consumption Government Investment Exports Imports
(C) Spending (G) (I) (X) (M)

Year £m £m £m £m £m

2007 1021 326 294 477 538

2008 1016 333 281 485 528

2009 982 337 240 445 476

2010 987 337 254 472 518

2011 985 337 260 499 523

2012 1000 345 262 502 539

2013 1018 344 271 510 547

2014 1044 349 294 512 560

2015

Consumption is far and away the biggest component of AD Source: HM-Treasury Databank
 Aggregate Demand
The components of aggregate demand are:
• Household spending on goods and services (C)
• Gross Fixed Capital Investment Spending (I)
• Value of the Change in Stocks (Inventories) (I)
• Government Spending on Public Services (G)
• Exports of Goods and Services (X)
• (minus) Imports of Goods and Services (M)

GDP (expenditure-based) is the actual value of expenditure

Changes in AD are key to understanding fluctuations in a cycle e.g.
recession and recovery, boom and slowdown stages
 AGGREGATE DEMAND

• The quantity of national output which is

purchased at a given price level.
• Total demand made up of consumption
spending, investment spending, government
spending and net exports.
• AD = C + I + G + (X – M)
2.1 GDP and its Determinants GDP

The Components of GDP

The expenditure approach to measuring GDP measures the total spending on a nation’s output
by households, firms, the government and foreigners. The four types of spending are outlined
below:
Household Consumption (C):
The purchase by households of all goods and services, including:
• Non-durables: bread, milk, toothpaste, t-shirts, socks, toys, etc...
• Durables: TVs, computers, cars, refrigerators, etc...
• Services: dentist visits, haircuts, taxi rides, accountants, lawyers, etc…
Gross Private Domestic Investment- (Ig)
• All final purchases of machinery, equipment, and tools by businesses.
• All construction (including residential).
• Changes in business inventories
 If total output exceeds current sales, inventories build up.
 If businesses are able to sell more than they currently produce, this entry will be a
negative number.
2.1 GDP and its Determinants GDP

The Components of GDP

The expenditure approach to measuring GDP measures the total spending on a nation’s output
by households, firms, the government and foreigners. The four types of spending are outlined
below:
Government Purchases (of consumption goods and capital goods) - (G)
• Includes spending by all levels of government (federal, state and local).
• Includes all direct purchases of resources (labor in particular).
• This entry excludes transfer payments since these outlays do not reflect current
production.
Net Exports- (Xn)
• All spending on goods produced in the U.S. must be included in GDP, whether the
purchase is made here or abroad.
• Often goods purchased and measured in the U.S. are produced elsewhere (Imports).
• Therefore, net exports, (Xn) is the difference: (exports - imports) and can be either a
positive or negative number depending on which is the larger amount.
 C = Consumer spending

• National consumer spending on all final goods

and services.
• Private spending on food, transport, housing,
household operation, apparel, recreation and
other final goods and services.
 CONSUMPTION
Any induced change in consumption will change AD. C will
change with a change in disposable income. This could be
brought about by a change in income tax or transfer payments.
• Interest rates will affect levels of consumption.
• Wealth effects
• consumer confidence may also change levels of
consumption
• Income tax
• Consumer Indebtedness
Changes in Expectations Current •When confidence falls, we see an
spending is affected by anticipated increase in saving and businesses
income and inflation postpone investment projects because of
worries over weak demand and lower
expected profits.
Changes in Monetary Policy – i.e. a •If interest rates fall – this lowers the cost
change in interest rates of borrowing and the incentive to save,
encouraging consumption & investment
•There are time lags between changes in
interest rates and AD

Changes in Fiscal Policy Fiscal Policy •Income tax affects disposable income
refers to changes in government e.g. lower income tax raises disposable
spending, taxation and borrowing income and should boost consumption.
•A budget deficit is a net injection of
aggregate demand
Economic events in the world •A depreciation in a currency makes
economy International factors such as imports dearer and exports cheaper - the
the exchange rate and foreign income net result should be that UK AD rises
•An increase in overseas incomes raises
demand for exports. In contrast a
recession in a major export market will
lead to a fall in exports and an inward
shift of aggregate demand.
Changes in household wealth •Changing share and property prices
affect the level of wealth
•Declining asset prices can hit confidence
/ a fall in expectations

Changes in the supply of credit •The availability of credit is vital for the
smooth functioning of most modern
economies
•Many banks and other lenders are now
more reluctant to lend
•Interest rates on different loans have
become more expensive
 I = Investment spending.

• Spending by producers - both private and

government – on capital goods.
 INVESTMENT
The two major factors affecting levels of investment are interest rates
and business confidence.
• If interest rates increase, investment decreases.
• Income levels
• If business confidence increases, investment increases.
• Role of technology
• Corporate taxes
• Corporate Indebtedness
• Government Policies
• Macroeconomic environment
 G = Net Government spending

• Government spending on final goods and

services.
• Includes state spending on materials, services,
wages etc.
• Subtracted from spending is money collected
through taxation.
 Government Spending

• Is influenced by the political process. The level

may change depending on the stage of the
election cycle and the political situation.
• Some countries have introduced Fiscal
Responsibility Laws commits Governments to
running budget surpluses so the focus on long
term goals
• Could be current, capital or transfer payments
 G – Net government spending

• Tax rates affect the level of Government

revenue.
• The level of economic activity has an influence
on Government revenue. In a boom
Government collects more income tax as
incomes rise.
 X-M = Net Exports
• Export receipts is the income earned from export of
goods and services. These are products produced in HK
(but sold overseas) and should be included.
• Import payments are excluded as the products are
produced overseas and therefore should not be
included.
Foreign Trade influenced by:
• Foreign Incomes
• Exchange rates
• Trade protectionism
 NET EXPORTS
• The exchange rate, overseas incomes tastes
and preferences, trading conditions and
barriers and access to overseas markets will
have an influence on exports.
• Imports are largely affected by the exchange
rate, the domestic income level and domestic
business confidence.
2.2 Aggregate Demand and Aggregate Supply
Aggregate
Demand

The Components of Aggregate Demand – Consumption (C)

As one of the components of aggregate demand, consumption refers to all the spending done by
households on goods and services. The level of consumption in a nation depends on several
factors.
The determinants of Consumption:
Refers to the after-tax incomes of households. As disposable income rises, C increases. If
Disposable Income disposable income falls, C will fall.

When value of existing wealth (real assets and financial assets) increases, households tend
Wealth to spend more on goods and services. When wealth decreases, consumption decreases.

If households expect prices or their incomes to rise in the future, then today C increase,
Expectations shifting AD out. If they expect lower prices or incomes, then C will likely decrease, as
households choose to save more for the hard times ahead.
Lower real interest rates lead to more C, as savings becomes less appealing and borrowing
Real Interest Rates to buy durable goods can be done more cheaply.
When consumers increase their debt level, they can consumer more in the short-run. But if
Household Debt household debt is too high, C will eventually decrease

Higher taxes decreases disposable income and causes C to fall. A decrease in taxes shifts
Taxation both C outwards. Taxes are set by government as part of fiscal policy.
 Shocks to Aggregate Demand
• Shocks to aggregate demand
• Many unexpected events cause changes in the level of demand, output and
employment
• These events are called “shocks”. Some of the causes of AD shocks are as follows:
• A large rise or fall in the exchange rate – affecting export demand and second-round
effects on output, employment, incomes and profits of businesses linked to export
industries.
• A recession in main trading partners affecting demand for exports of goods and
services.
• A slump in the housing market or a big change in share prices
• An event such as the credit crunch (global financial crisis) – involving a fall in the
amount of credit available for borrowing by households and businesses.
• An unexpected cut or an unexpected rise in interest rates or change in
government taxation and spending – for example deep cuts in government spending
as part of fiscal austerity
These shocks will bring about a shift in the aggregate demand curve
2.2 Aggregate Demand and Aggregate Supply
Aggregate
Demand

The Marginal Propensities

As national income rises or falls, the level of consumption among households varies based on the marginal
propensity to consume. Besides consuming with their incomes, households also save, pay taxes and buy
imports. The proportion of any change in income that goes towards each of these is known as the marginal
propensity
• The Marginal Propensity to Consume (MPC): this is the proportion of Consumption is a
any change in national income (Y) that goes towards consumption (C) component of AD, while
by households: savings, buying imports,
• The Marginal Propensity to Save (MPS): The proportion of any and paying taxes are all
change in national income (Y) that goes towards savings (S) by leakages from the nation’s
households: circular flow. These three
• The Marginal Propensity to Import (MPM): The proportion of any together are known as the
change in national income (Y) that goes towards buying imports (M) marginal rate of leakage
by households: (MRL). These are the four
• The Marginal Rate of Taxation (MRT): The proportion of any change things households can do
in national income (Y) that goes towards paying taxes (T) by with any change in their
households: income. Therefore,
2.2 Aggregate Demand and Aggregate Supply
Aggregate
Demand

Calculating Marginal Propensities to Consume and Save

Study the table below, which shows how consumption, taxes, savings and imports change
following a $1 trillion increase in US households income.
Assume US household income increases from $10 trillion to $11 trillion
Income: Consumption Taxes Savings Imports

$10 trillion $7 trillion $1.5 trillion $1 trillion $0.5 trillion

$11 trillion $7.5 trillion $1.6 trillion $1.25 trillion $0.55 trillion

• The Marginal Propensity to Consume (MPC)

• The Marginal Propensity to Save (MPS):
• The Marginal Propensity to Import (MPM)
• The Marginal Rate of Taxation (MRT)
2.2 Aggregate Demand and Aggregate Supply
Aggregate
Demand

Calculating Marginal Propensities to Consume and Save

Study the table below, then answer the questions that follow:
Personal consumption ("personal outlays") and Personal savings in the
US

Source: http://www.bea.gov/

1. Describe the changes in US personal income between each of the years from 1999-2007.
2. Calculate the marginal rate of taxation for each of the years ()
3. Calculate the marginal propensity to save for each of the years ()
4. Calculate the marginal propensity to consume for each of the years (in this table,
consumption is referred to as ‘personal outlays’. ()
2.2 Aggregate Demand and Aggregate Supply
Aggregate
Demand

The Components of Aggregate Demand – Investment (I)

Investment is the second component of a nation's aggregate demand. Investment is defined as
spending by firms on capital equipment or technology and by households on new homes.
The determinants of Investment:
Interest is the cost of borrowing money. Firms will borrow more to invest in new capital
The Real Interest Rate when the interest rate is low, and invest less when interest rates are high.

If firms are confident about the level of future demand for their products, they are more
Business Confidence likely to invest now. If confidence is low, firms will withhold from making new investments

New technology tends to spur new business investment, as firms rush to keep their
Technology manufacturing techniques as modern as efficient as possible and to produce the latest
goods and services that consumers are demanding.
When firms can keep a larger share of their revenues (i.e. when taxes are lower) they may
Business taxes invest more. Higher business taxes discourage new investments.
If a firm’s factories have excess capacity (meaning they are currently producing below the
The degree of excess
level they are capable of) firms will be less likely to invest since output can be increased
capacity
without acquiring new capital.

If firms expect prices of their goods to be higher in the future, they are more likely to invest
Expectations: now. If lower prices are expected, firms have less incentive to invest now.
 2.2 Aggregate Demand and Aggregate Supply
Aggregate
Demand

The Investment Demand Curve (for loanable funds)

The real interest rate is the most important determinant of the level of investment in a nation.
Study the graph below to understand the relationship between interest rates and investment.
The Investment Demand Curve: The graph shows the
Investment Demand demand for loanable funds, which borrowers need to
invest in capital or new homes. Notice:
• With a real interest rate of 8%, few firms will want
to invest in new capital as there are very few
real interest rate

8%
investments with an expected rate of return greater
than 8%
• When real interest rates are 3%, the quantity of
funds demanded for investment is much higher,
3%
since there are more projects with an expected rate
of return greater than 3%
DI • Firms will only invest if they expect the returns on
Q1 Q2 the investment to be greater than the real interest
rate (marginal benefit must be greater than the
Quantity of Funds Demanded marginal cost)
for Investment
 2.2 Aggregate Demand and Aggregate Supply
Aggregate
Demand

Shifts in the Investment Demand Curve

As a component of aggregate demand, the level of investment in the economy depends
primarily on the interest rate, but also on other determinants of investment.
Investment Demand
If one of the determinants of investment changes,
the level of investment will increase or decrease
at every interest rate
• If business confidence improves, a new
real interest rate

technology is developed, business taxes are

lowered, firms are producing at full capacity or
5%
D2 producers expect higher future prices,
Investment demand will shift from Di to D2
• If business confidence worsens, business taxes
D3 increase, firms have lots of excess capacity or
DI
producers expect prices to be lower in the
Q3 Q1 Q2
future, Investment demand will shift from Di to
Quantity of Funds Demanded D3.
for Investment
2.2 Aggregate Demand and Aggregate Supply
Aggregate
Demand

The Components of Aggregate Demand – Net Exports (Xn or X-M)

Another components of the total demand for a nation’s output is export revenues. Net exports
refers to the revenue earned from the sale of exports to the rest of the world minus the
expenditures made on imports from abroad. Net exports equals exports (X) – imports (M)
The Determinants of Net Exports

Foreign and Domestic If the incomes of households in other nations rise, then demand for a country’s exports
should increase and net exports should rise. On the other hand, if domestic incomes rise,
Incomes demand for imports will increase and net exports will fall.

The exchange rate is the value of a country’s currency relative to other currencies. As the
The Exchange Rate exchange rate increases, a country’s goods become more expensive and therefore less
attractive to foreign consumers, while imports become cheaper, causing net exports to fall.

Protectionism refers to policies put in place by government intended to reduce amount of

trade between one nation and others. Reducing protectionism will increase demand for
Protectionism imports in a country, and may cause net exports to fall. On the other hand, it may also
increase demand for exports, causing net exports to increase.

If a country’s goods become more appealing to foreign consumers, demand for them will
Tastes and preferences rise and net exports will increase.
2.2 Aggregate Demand and Aggregate Supply
Aggregate
Demand

The Components of Aggregate Demand – Government Spending (G)

Government spending is the final component of aggregate demand. The level of government
spending in a nation is determined by the government’s fiscal policy.

Fiscal Policy: Changes in the levels of taxation and government spending meant to expand or contract the
level of aggregate demand in a nation to promote macroeconomic objectives such as full employment,
stable price and economic growth. There are several key concepts relating to fiscal policy to consider:
• The government’s budget: Changes in the level of government spending are reflected in the
government’s budget, towards which tax revenues go in order to finance government expenditures.
• Contractionary fiscal policy: If the government reduces its spending and / or increases the level of
taxation, aggregate demand will decrease and shift to the left
• Expansionary fiscal policy: If the government increases its expenditures and / or decreases the level of
taxation, aggregate demand will increase and shift to the right.
• Budget deficit: If, in a particular year, a government runs a deficit, meaning its expenditures exceed tax
revenues, then government spending will contribute to AD that year and cause it to increase and shift
out.
• Budget surplus: If, in a particular year, a government runs a surplus, meaning it spends less than it
collected in taxes, then fiscal policy will subtract from aggregate demand, shifting it to the left.
2.2 Aggregate Demand and Aggregate Supply
Aggregate
Demand

Fiscal Policy’s Affect on Aggregate Demand

In 2007 the US was about to enter a recession. In response, the government announced an
expansionary fiscal policy aimed at increasing AD. The table below summarizes the components
of and the desired effects of the government’s policy.
Fiscal Policy Action Desired Effect on AD
Tax rebates to 137 million people. A rebate of up to $600 Lower taxes mean higher disposable income, which means
would go to single filers making less than $75,000. Couples more consumption, shifting AD out, increasing output and
making less than $150,000 would receive rebates of up to reducing unemployment
$1,200. In addition, parents receive $300 rebates per child.

Business tax breaks. The bill would temporarily provide Lower business taxes increase the expected rates of return
more generous expensing provisions for small businesses in on investments, shifting investment demand out, increasing
2008 and let large businesses deduct 50% more of their I, shifting AD and AS out (since there's more capital),
assets if purchased and put into use this year. increasing GDP and reducing unemployment

Housing provisions. The bill calls for the caps on the size of Since real estate is a major source of wealth for Americans,
loans that may be purchased by Fannie Mae (FNM) and anything the gov't can do to increase demand for new
Freddie Mac (FRE, Fortune 500) to be temporarily raised homes will lead to an increase in home values, thus
from the current level of $417,000 to nearly $730,000 in the household wealth, a determinant of consumption. Higher
highest cost housing markets. It also calls for an increase in home prices cause more consumption, stronger AD, more
the size of loans that would be eligible to be insured by the output and less unemployment
Federal Housing Administration.
2.2 Aggregate Demand and Aggregate Supply
Aggregate
Demand

The Spending Multiplier and Aggregate Demand

When a particular component of AD changes (either C, I, Xn or G) the change in total spending
the economy experiences will be greater than the initial change in expenditures. This is known
as the multiplier effect.
Example of the multiplier effect in action: Assume the US government decides to increase spending on
infrastructure project (roads, bridges, etc…) by $100 billion. What happens to this money?
• $100 billion will be earned by households employed in the infrastructure projects.
• Of that, some percentage will be saved, paid in taxes and used to buy imports. But some percentage will
be used for consumption.
• The income earned from the $100 billion government spending and then spent on consumption be
earned again by other households!
• Assume that the MPC = 0.8. this means that of the $100 billion, $80 billion will be spent again by the
households that earned it. There is now an additional $80 billion of new income, of which…
• $64 billion will be spent again (0.8 x 80). In this way, the initial change in government spending of $100
billion is MULTIPLIED throughout the economy to create even more total spending.
• The size of the Multiplier is determined by the MPC, and can be calculated as:
2.2 Aggregate Demand and Aggregate Supply
Aggregate
Demand

The Spending Multiplier and Aggregate Demand

The table below shows the changes in total spending that will result from an initial change in
expenditures of $100 in an economy, based on different marginal propensities to consume.
Study the data and then answer the questions that follow.
1. What is the relationship between
Marginal Initial change in
Size of the
Total change in the MPC and the size of the
spending spending multiplier?
Propensity to Expenditures (C, spending in the
multiplier (1/1-
Consume I, G or Xn) economy 2. What is a logical explanation for
MPC)
this relationship?
3. Under what circumstance will a
0.2 +100 1.25 125
particular increase in government
0.4 +100 1.67 167 spending be most effective, when
the MPC is low or when it is high?
0.6 +100 2.5 250 4. Does the multiplier effect work
when the initial change in
0.8 +100 5 500 spending is negative? What would
this mean for an economy in which
0.9 +100 10 1000 business confidence is falling?
2.2 Aggregate Demand and Aggregate Supply
Aggregate
Demand

The Spending Multiplier and Aggregate Demand

The effects of the spending multiplier can be seen on an aggregate demand curve. Assume, for
example, an economy experiences $50 million increase in its net exports (perhaps due to a
depreciation of its currency). The MPC in this economy is 0.6.
The Spending Multiplier = The Aggregate Demand Curve

Initial change in spending = $50 million

• The effect of the initial increase in Xn is shown by
a shift from AD1 to AD2. At P1, the level of output

Average Price level

demanded only increases to Y2 P1

Final change in spending = $50 million x 2.5 =

$125 million AD3
• The ultimate effect on AD will be a shift to AD3. AD2
Assuming the price level remained at P1, the total AD1
demand for output is now at Y3. Y1 Y2 Y3
Real Gross Domestic Product (rGDP)
2.2 Aggregate Demand and Aggregate Supply
Aggregate
Demand

The Tax Multiplier and Aggregate Demand

When a component of AD changes, total spending will change depending on the spending
multiplier. But a factor that determines one of the components of AD changes (taxes in this
case), the effect on AD will be less direct.

The Tax Multiplier: When the government reduces taxes by a certain amount, households’
disposable income increases, and therefore consumption increase, leading to an increase in AD.
The tax multiplier tells us the amount by which total spending will increase following an initial
decrease in taxes of a particular amount.

Remember, the MRL is the marginal rate of leakage. It refers to the things households do with
any change in income that do not contribute to the nation’s total demand*.

Why two formulas? Two formulas are provided because in AP Economics, students are not expected to learn
the MRL. The assumption is that MPC+MPS=1. However, in IB Economics, we must consider the MPS, MPM
and the MRT, so MPC+MRL=1. The formulas are the same, but while IB students must remember the one on
the left, AP student need only consider the one on the right.
2.2 Aggregate Demand and Aggregate Supply
Aggregate
Demand

The Tax Multiplier and Aggregate Demand

If we know the MPC for a country, and we know how much taxes are cut by, we can calculate the
tax multiplier and determine the ultimate change in total spending that will result from the tax
cut. Remember that the MRL is always equal to 1-MPC.

Notice that at every level of

Marginal Size of the tax Total change in MPC, the change in total
Initial change in
Propensity to multiplier spending in the
Consume
Taxes
(-MPC/MRL) economy spending that results from a
$100 tax cut is LESS THAN
the change in total spending
0.2 -100 -0.25 25 that resulted from a $100
increase in spending (from
0.4 -100 -0.67 67 an earlier slide). The tax
multiplier will ALWAYS be
0.6 -100 1.5 150 smaller than the spending
multiplier, a proportion of
0.8 -100 -4 400 any tax cut will be leaked
before it is spent.
0.9 -100 -9 900
Examples of Causes of Shifts in Aggregate Demand

Fall in AD Increase in AD
Depreciation of the
Fall in exports
exchange rate

Cut in government Cuts in direct and indirect

spending taxes

Higher interest rates Increase in house prices

Decline in household Expansion of supply of

wealth credit + lower interest rates
Focus on Key Causes of Shifts in Aggregate Demand
Changes to Monetary Policy
• Changes in official monetary policy interest rates
• Change in the supply of money and credit
• Change in the value of a country’s exchange rate

Changes to Government Fiscal Policy

• Changes in the level of direct / indirect taxes
• Changes in government (state) spending
• Changes in government (fiscal) borrowing

Business and Consumer confidence

• Planned capital investment spending by businesses
• Consumer confidence and retail spending
 External Shocks to Aggregate Demand
Many unexpected events cause changes in demand, output and
employment. These events are called external “shocks”.

A large rise or fall in the value of the exchange rate

A recession, slowdown or boom in one or more of a nation’s key

trading partner countries

A slump in the housing market / construction sector of a country

An event such as the Global Financial Crisis which caused a fall in

the supply of credit available to businesses and households

A large change in commodity prices for a country

that is a commodity exporter e.g. of oil
 Exports of Goods and Services (X)
Exports are goods and services sold to other countries. Exports are
an injection into a nation’s circular flow of income and spending

The exchange Many factors affect the

rate – a level of demand for a
Relative Prices
stronger nation’s exports – some of
of exports in
currency makes these are shown on the left
World Markets
exports more
expensive

Non-Price
Strength of
Demand
Aggregate
Factors e.g.
Demand in Key
Design and
Export Markets
Branding
 The Net Trade Balance (X-M) and Aggregate Demand
The net trade balance is measured the value of exported goods and
services minus the value of imported products
450
Balance of Trade for China 2000-2014
A trade surplus means 400
that X>M – aggregate
demand will increase 350

Trade balance in billion U.S. dollars

300

A trade deficit means 250

that M>X – aggregate
200
demand will fall
150

If X=M, then the trade 100

balance is zero, external
50
trade will have a
neutral effect on AD 0
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
 Public and Private Sector Debt

• Public sector debt is owed by central and local

government and by public (state-owned) corporations
– Debts owed by state-owned banks are included in national
debt
• Private sector debt is owed by private businesses and
households.
– Companies may have borrowed to finance investment
(corporate sector debt)
– Households have loans for example credit card debt and
mortgages on properties.
• Financial debt is also part of the private sector – this is
the outstanding (unpaid) debts of banks and financial
corporations - for example the level of bad debts on
loans to businesses and to the housing market