Components of AD
1. Consumption( C): consumption is a aggregate of all
spending of domestic, households on goods and services during a period of time.
C is the function of household income and MPC (marginal propensity to consume).
2. Investment ( I ):it is gross domestic private
investment. It measures the total spending of the firm on capital equipment. I
is the function of national output and interest rate.
3. Government spending (G): ‘G’ refers to Government
spending and measures a country’s government expenditure on goods and services.
4. Net exports (X-M) : net exports is the total income
earned from the sale of X to foreigners minus the total amount spent by
nationals of a country.
Remember, net export can be
negative or positive. Google it out?
The function of AD = C + I + G + (X – M)
Why AD curve slopes downwards?
Under microeconomics the demand curve slopes
downwards because of income affect, substitution effect and diminishing
marginal utility But in macroeconomics the following effects leads to downwards
slope of the curve.
A. The Wealth Effect: When the price level is high, the purchasing power or the real value of
nation’s households’ wealth and savings is reduced. People will be worse off
and cut back on their spending of goods and services. Therefore, as the
price level rises, less output is demanded, resulting in upward movement along
the AD curve. But with the fall in price level, the real value of wealth
increases, people would feel better off and they would increase their spending,
so more output is demanded therefore there is downward movement along AD curve.
B. The Interest rate effect: the bank raises the interest rates in response to
increase in price level. Household and firms who want to borrow from bank
decrease. The total quantity demanded decreases resulting in decrease in AD due
to decrease in consumer purchase financed by borrowing as well as investment
spending by the firms and vice versa.
Therefore, increase in price-level would decrease in spending and fall in
quantity of output demanded lead to downward movement along AD curve. Similarly
if price level falls there is increase in spending and rise in quantity of
output demanded leading to upward movement of AD curve.
C. The net export effect or
the international trade effect: Rise in
price level in the host country will make exports more expensive to
foreign buyers and the demand for exports will fall. The opposite result from
an increase in the price level that make domestic output less attractive to
foreigners and foreign products more attractive to domestic consumers. If seen
carefully this is same as substitution effect. Therefor with the rise in price
level the X(Exports) fall and M(imports) rise, so X-M falls. Falling net
exports means (downwards movement of AD curve) and vice versa leads to upward
movement along AD curve.
SHIFT IN AD CURVE [
due to change in any one C,I,G,(X-M)]
A.Change in
consumers spending due to any of the following.
i. Change in wealth: wealth is the value of assets that are in possession of household like
value of their homes, stocks held by them, values of bonds, and jewelry etc. an
increase in any of these psychologically makes am person in possession feels
wealthier and they spend more leading to shift in AD to right (AD2).
When there is decrease in wealth the AD curve shifts to left(AD3).
ii. Change in future expectation about income or
economy.
Due to optimism about increase in future income or
future of economy, the consumers are likely to spend more in present. This will
shift the AD curve towards right (AD2). On the other hand
expectation of falling income in future and pessimistic expectations about
economy’s future would decrease spending and shift AD curve to left (AD3)
iii. Change in interest rates.
Consumers spending are always sensitive to interest
rate changes. Rise in interest rates leads to expensive borrowings, results in
lower consumer spending. This in turn leads to leftward shift in AD curve (AD3).
If interest rates fall, borrowings become cheaper and demand rises leading to
right shift in D curve (AD2)
iv. Change in personal income tax.
v. The government decision to increase personal income
tax on household incomes, their disposable income will fall resulting in lower
AD and shift of AD curve towards left (AD3. If personal income tax
is lowered. It will increase the disposable income of consumers. This will
directly affect their consumption and AD will increase leading to right shift
in AD curve (AD2)
vi. Change in attitude towards spending.
After a war of major natural calamity the
households often becomes cautious as regards to their spending habits. They may
decide to spend less at a given level on income and would save more and vice
versa would lead to more spending on consumer goods.
B. Change in Investment
spending due to any of the following.
i. Change in future expectations.
Investment will increase if the economy is moving
towards boom. The businesses are optimistic about future so investment will
also leap forward. This will shift the AD curve to right (AD2) but
if business sees, pessimism will shift AD curve to left. (AD3)
ii. Improvement in technology
Better technology always gives businesses a boost
for acquiring it. Thus, the investment spending will increase and vice versa.
iii. Changes in business tax /corporate taxes.
As a part of its fiscal policy the government
increases its taxes on business profits, the firms spending power curbed due to
less profit after taxes. This results in leftward shift in AD curve (AD3).
On the other hand, decrease in taxes will give a boost to AD and curves
rightward shift (AD2)
iv. Legal policy changes or institutional changes.
If the laws enacted by the government do not favour
small businesses, there is a great impact on investment spending in an economy.
In transition economies, the small firms cannot borrow easily for financing
investment. Thus, investment stay less resulting in left shit in AD curve (AD3).
But increasing access to credit and securing property rights would
benefit small entrepreneurs and investment spending will increased resulting in
AD right shift (AD2)
C. Change in EXIM (X-M) due to any of the following.
i. Real national income change.
If real income of host country increases, it will
purchase more goods and services from other country. This will lead to more
exports from neighbouring countries. This will shift neighbouring country’s AD
curve to right (AD2). But if on the other hand the neighbouring
country’s real income increases its AD curve will shift to left (AD3)
ii. Exchange rates change.
An exchange rate is the price of country’s currency
in terms of another country’s currency. If host country’s currency price
increases (appreciates) in relation to other neighbouring country, its products
become more expensive to its neighbours. The exports of host country will fall
and its AD curve will shift left (AD3) the host country’s currency
appreciation effects are double fold. Fall in X and increase in M so net export
falls (X-M falls) its AD curve will shift left (AD3) but if the
price of this host country’s currency decreases (depreciates) net exports (X-M)
increases and AD curve will shift to right (AD2)
D. Changes in Government spending due to any of the following
i. Change in political priorities.
Increase in overall government spending shifts AD
to left. These spending could be on merit goods, public goods, subsidies and
pensions wage payments and purchase of goods for its own use. If the
expenditure made by government decreases the AD curve shifts towards right.
ii. Deliberately changing AD.
Government’s own spending used to influence the
overall AD. This affects the shift of AD curve towards right (AD2)
Shifts in short run AS
The SRAS curve shows relationship between price
level and quantity of real GDP produced by firm with no change in resource
price (wage price)
Causes of shift in SRAS curve.
i. Change in wages.
It is the main component of change in SRAS. Wage is
a major part of firms cost of production. If the nominal ages increase with
constant price levels, the firms’ cost of production will rise resulting in
left shift of SRAS curve (SRAS3) from (SRAS1). This shows
that a smaller quantity of real output is produced and supplied. If the wages
decrease with constant price level, the firms’ cost also drops leading to tight
shift from SRAS1 to SRAS2
ii. Subsidies.
Subsidies involve money transferred from government
to firms. It has an opposite effect than taxes. If the subsidies increases, the
SRAS curve will shift to right from SRAS1 to SRAS2 but
if they decrease the SRAS 1 will shift toward left SRAS3 .
iii. Business taxes
A business tax is like costs by the firm.
Therefore, if the government taxes are increased on firms, the total cost of production
will increase, directly affecting the quantity produced and supplied. This will
shift SRAS1 to SRAS3. On the other hand, lower taxes
would shift the SRAS curve towards right.
iv. Supply shocks
Supply shocks are sudden impacts on the short run
AS. Adverse supply shocks causes leftward shift to AS from SRAS1 to
SRAS3 . Examples of supply shocks could be war, natural
calamity, destruction of physical capital and disruption of economy or
unfavorable weather conditions etc. nowadays there are fluctuations in oil
prices leading to supply shocks in non-oil producing countries.
However there are various other factors like change in non-labour costs
like oil,equipment, capital goods, land inputs that would impact the SRAS curve
resulting in either right or left shift.
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