How Changes on Aggregate Demand Influence Price Levels

Diana Gaita Economics FB1 Discuss how changes on aggregate demand influence price levels, output levels and employment. The meaning of “aggregate” is added together. All of the elements introduced in microeconomics are totaled in macroeconomics. Aggregate demand and supply analysis brings together the amount that consumers wish to consume and firms wish to produce at any price levels. Aggregate demand (AD) is the total demand for final goods and services in the economy (Y) at a given time and price level. Also it is the amount of goods and services that will be purchased at all possible price levels in the economy.

This is called the demand for the Gross Domestic Product of a country when inventory levels are static. The formula for aggregate demand is AD= C + I + G + (X-M); C – Consumption, I – Investment, G – Government Spending, X – Exports, M – Imports. The AD curve is downward sloping but it’s not because people buy more when things are cheaper. There are three ways to explain the downward sloping of the AD curve: * Lower prices in an economy mean international competitiveness, so there are more exports and fewer imports. In other words, net exports are higher at lower prices. The total amount of spending will be approximately equal to weather prices are low or high people have almost the same amount of money to spend, so the area under the curve is fairly constant. This is known as the real balance effect. * At higher price levels, interest rates are likely to be rising by the monetary authorities. This means that investment, a component of aggregate demand, will fall and saving might increase. There are three main components of aggregate demand: * The Price Level and Consumption:  The Wealth Effect 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. When consumers feel insecure with their job security and incomes they are more likely to save money. Since there is a positive relationship between consumption and aggregate demand, an increase in consumption will result in an in crease in the aggregate demand. This shift will contribute to higher levels of output and this could have positive and negative effects. An increase in output usually results in higher levels of employment, since more workers are needed to produce the goods and services.

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When consumption shifts the AD curve to right, the general price levels tend to increase. This occurs because consumers demand more goods and services and the aggregate supply may take a long time to respond to the changes due to limited resources. This can lead to a demand-pull inflation. However, this is not always the case. Countries try to increase their aggregate supply in order to respond to the changes in AD. If they achieve this, the output will rise due to an increase in consumption, promoting economic growth and employment, but prices will remain the same or rise by a smaller percentage, preventing the high level of inflation. The Price Level and Investment: The Interest Rate Effect This usually occurs when 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. This means when firms and individuals finance the capital stock invest in such things as machinery, this can result in employment rate decreasing. Interest rates play a big role when firms decide upon how much money to invest. If they are too high, it is a discouragement for firms to borrow as its costs rise, thus decreasing their disposable income decreases.

However, investment is not only affected by interest rates. The interest elasticity of demand tends to be very low since investors have a variety of factors to take into consideration when deciding upon how much and where to invest. In some cases, investors do not borrow money from banks, so interest rate fluctuations will not have any significant effect on levels of investment. Confidence in future sales patterns and government incentive and regulations will also affect the investment levels. Another injection in the economy is the multiplier effect of the investment.

In the economy, the money invested today will have a greater impact such as increasing the levels of output in the future. This is because investment rises the capital stock. With an evolution in technology, the machineries help production become faster and cheaper, thus contributing greatly to increasing the output in long-term. * The Price Level and Net Exports:  The Exchange-Rate Effect Exports represent an injection into the circular flow of income, in that the money paid for goods and services sold abroad enters the domestic flow of income.

Imports mean that there is an outflow of money, and exports minus imports gives the total movement of funds known as net exports. There are a number of reasons why the value of net exports might change. If the exchange rate increases in value against other currencies, imports become cheaper and exports more expensive on world markets. Over time, people respond to these relative price movements and the demand for exports falls and the demand for imports rises. A stronger currency will worsen net exports, whereas a weaker currency will improve the figure.

Also, for example if a fall in the UK price level causes UK interest rates to fall, the real exchange rate depreciates, which stimulates UK net exports. The increase in net export spending means a larger quantity of goods and services demanded. However, in the short run the price elasticity of demand for exports and imports tends to be low. This may be because contracts have been signed for specific deals in international trade, or because the traded components are a very small percentage of firms’ overall costs.

In conclusion, the aggregate demand changes in response to a change in any of its components. A raise in consumption, investment, exports and net exports will shift the AD curve to the right. This usually results in an increase in prices and an increase of the total output of the economy, but there are many other factors affecting this process. All societies experience short-run economic fluctuations around long-run trends, these fluctuations are irregular and largely unpredictable.

When recessions occur, real GDP and other measures of income, spending, and production fall, and unemployment rises. Economists analyze short-run economic fluctuations using the aggregate demand and aggregate supply model. According to the model of aggregate demand and aggregate supply, the output of goods and services and the overall level of prices adjust to balance aggregate demand and aggregate supply. The aggregate-demand curve slopes downward for three reasons:  a wealth effect, an interest rate effect, and an exchange rate effect.

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