Aggregate demand. Student workpoint 14.1 Be reflective Make a list of five durable goods and five non-durable goods used in your household.

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1 Aggregate demand 14 By the end of this chapter, you shoud be abe to: distinguish between demand and aggregate demand (AD) define and iustrate aggregate demand define and describe the components of AD expain the determinants of the components of AD iustrate shifts of the AD curve expain how governments can use monetary and fisca poicy to ater the eve of AD in an economy expain the nature of a government budget. Aggregate demand (AD) If you are confident in your understanding of the microeconomic concepts of demand and suppy, then you have the necessary groundwork to understand the macroeconomic concepts of aggregate demand and aggregate suppy. In this chapter we begin our macroeconomic anaysis by examining the concept of aggregate demand. By definition, aggregate demand is the tota spending on goods and services in a period of time at a given price eve. On a diagram it ooks very much ike the demand curve in the sense that it is downward-soping as shown in Figure Deveoping countries ike India must make sure that their integration in the goba economy heps ead to an increase in jobs, a more equitabe distribution of income, and decreased poverty. The most important way of doing this is for the government to maintain as high a rate of aggregate demand as possibe. webindia123.com, January 8, 26 on the x-axis, the macroeconomic aggregate demand curve has the tota quantity of a goods and services, which is nationa output. Given what you earned in Chapter 13, you wi aso reaise that nationa output is equivaent to nationa income and nationa expenditure. In macroeconomic anaysis the x-axis is commony abeed rea output (the vaue of nationa output adjusted for infation) or nationa income (Y). Thus the aggregate demand curve shows the reationship between the average price eve and rea output. The two different diagrams are shown to hep you see and earn the difference between the microeconomic concept of demand and the macroeconomic concept of aggregate demand. The AD diagram iustrates the inverse reationship between the average price eve and the tota rea output demanded; at a ower average price eve, a higher quantity is demanded. Essentiay, this is the Law of Demand on an aggregate eve. The word aggregate means tota. Therefore, in constructing an aggregate demand curve, we ook at the demand from a possibe sectors within the economy. This gives us the components of aggregate demand described in the next section. Consumption Consumption (C) is the tota spending by consumers on domestic goods and services. In ooking at consumer demand for goods we ook at two categories of goods durabe goods and non-durabe goods. Durabe goods are goods such as cars, computers, mobie phones, and bicyces that are used by consumers over a period of time (usuay more than one year). Non-durabe goods are goods such as rice, toiet paper, and newspapers that are used up immediatey or over a reativey short period of time. Student workpoint 14.1 Be refective Make a ist of five durabe goods and five non-durabe goods used in your househod. 17 Average price eve ($) (a) Aggregate demand Rea output = nationa income = Y Figure 14.1 (a) Macroeconomic aggregate demand curve; (b) microeconomic demand curve Price ($) However, the demand curve shows the reationship between the price of one good, e.g. soccer bas, and the demand for that one good. The fact that it is a demand curve for one market makes it a microeconomic concept. Macroeconomics considers the working of the whoe economy, incuding a the goods and services demanded. Where the microeconomic demand curve has the price of the one good on the y-axis, the macroeconomic aggregate demand curve has a measure of the average price eve of a goods and services. Where the microeconomic demand curve has the quantity of the one good (b) Demand Quantity (units) Investment Investment (I) is defined as the addition of capita stock to the economy. Investment is carried out by firms. Firms have two types of investment. Repacement investment occurs when firms spend on capita in order to maintain the productivity of their existing capita. Induced investment occurs when firms spend on capita to increase their output to respond to higher demand in the economy. The economy s capita stock incudes a goods that are made by peope and are used to produce other goods or services such as factories, machines, offices, or computers. Investment is not to be confused with buying shares or putting money in a bank we tend to ca this investment in everyday Engish, but it is, in fact, saving as it is a eakage from the circuar fow. Government spending Governments at a variety of eves (federa, state/provincia, municipa/city) spend on a wide variety of goods and services. These incude heath, education, aw and order, transport, socia security, housing, and defence. The amount of government spending (G) depends on its poicies and objectives. 171

2 172 Net exports (X M) Exports are domestic goods and services that are bought by foreigners. When the firms in a country se exports to foreigners, it resuts in an infow of export revenues to the country. Imports are goods and services that are bought from foreign producers. When imports are bought it resuts in an outfow of import expenditure. The net trade component of AD is actuay export revenues minus import expenditure, but it is simpified by noting it as exports minus imports (X2M). The figure can be either positive, whereby export revenues exceed import expenditure, or negative, whereby import expenditure exceeds export revenues. If the net figure is positive it wi add to AD but if the net figure is negative it wi reduce AD. Aggregate demand can be presented as a formua, C 1 I 1 G 1 (X 2 M), and as a diagram, as shown in Figure The shape of the AD curve When the average price eve in the economy fas from PL 1 to PL 2, the eve of output demanded by consumers (C) pus firms (I) pus governments (G) and the net foreign sector (X M) increases from Y 1 to Y 2. Note: You wi find that different books use different abes for the x-axis. You may find any of nationa income (Y), nationa expenditure, nationa output or rea output. Whichever one you choose, be sure that it is distinct from simpy quantity or Q, which woud indicate a singe market in a microeconomic anaysis. Changes in AD A change in the price eve wi resut in a movement aong the AD curve, from one eve of rea output to another. A change in any of the components of aggregate demand wi cause a shift in the demand curve as shown in Figure An increase in any of the components of aggregate demand wi resut in an increase in aggregate demand and a shift of the AD curve to the right from AD 1 to AD 2. A decrease in any of the components of aggregate demand wi resut in a fa in aggregate demand and a shift of the AD curve to the eft from AD 1 to AD 3. Changes in the components of aggregate demand What causes changes in consumption? Changes in income The most significant determinant of consumption is income. As incomes rise peope have more money to spend on goods and services, so consumption increases. In a growing economy where nationa income is rising, there wi be an increase in consumption and therefore an increase in aggregate demand. Average price eve ($) Figure 14.2 The aggregate demand curve Average price eve ($) PL1 PL2 Y1 Y2 AD = C+I+G+(X-M) Rea output = nationa income = Y AD3 AD1 AD2 Rea output Figure 14.3 Shifts in aggregate demand Changes in interest rates Spending on non-durabe goods is carried out with the day-to-day money that peope earn (their income). But some of the money that is used to buy durabe goods comes from money which peope borrow from the bank. When peope borrow money they must pay for the borrowed money by paying interest to the bank. If there is an increase in interest rates, which is essentiay the price of borrowed money, then there is ikey to be ess borrowing (because it is more expensive to borrow). Therefore consumption wi fa, resuting in a fa in AD. For exampe, borrowed money is usuay used to buy houses. To buy a house, most consumers get a oan for housing caed a mortgage. If interest rates increase then this oan becomes more expensive on a month-to-month basis. This means that peope wi have ess money to spend on other goods and services, so consumption wi fa. Aso, a rise in the interest rate makes saving more attractive; peope woud prefer to put their extra income in the bank to earn money rather than spend it on goods and services. This is another reason why changes in interest rates affect consumption. Overa, an increase in interest rates eads to a fa in consumption. On the other hand, a fa in interest rates wi ead to an increase in consumption, ceteris paribus, as it becomes more attractive to borrow money to spend on durabe goods and services. In addition, if interest rates fa then mortgage repayments may fa, eaving more money to spend on goods and services, and it becomes ess appeaing to save money in the bank when the return on the savings (the interest earned) is reativey ow. Changes in weath The amount of consumption depends on the amount of weath that consumers have. It is very important not to confuse the concepts of income and weath. Income is the money that peope earn. Weath is made up of the assets that peope own. This incudes physica assets, such as houses, art, antiques, or jeweery, and monetary/financia assets, such as shares in companies, government bonds, or bank savings. There are two main factors that can change the eve of weath in the economy. A change in house prices: When house prices increase across the economy, consumers fee more weathy and are ikey to fee confident enough to increase their consumption by saving ess or borrowing more. A change in the vaue of stocks and shares: Many consumers hod shares in companies. If the vaue of those shares increases then peope fee more weathy. This might encourage them to spend more. Aternativey, they might se those shares and then use the earnings to increase consumption. Changes in expectations/consumer confidence If peope are optimistic about their economic future then they are ikey to spend more now. For exampe, if they think that they are Student workpoint 14.2 Identify five goods or services that peope might need a bank oan to purchase. 173

3 ikey to get a promotion in the future due to a booming economy and strong saes then they wi fee more confident about taking a oan or using up savings. Thus, high consumer confidence is ikey to ead to increased consumption. However, if peope expect economic conditions to worsen then they are ikey to reduce their consumption today in order to save for the future. Economists reguary measure consumer confidence and put the information together in the form of a consumer confidence index or consumer sentiment index. An increase in the index indicates that confidence is rising; if this is the case, then consumer spending is ikey to rise as we. Househod indebtedness The extent to which househods are wiing and abe to borrow money affects consumption. If it is easy to borrow money (easy credit) and interest rates are ow then it is ikey that househods wi take on more debt by getting oans or using their credit cards and spending on goods and services wi rise. However, if interest rates then rise, then househods wi have to spend more to re-pay their oans and mortgages (the origina amount borrowed pus the interest). In the short run they might simpy continue to borrow but utimatey the debt wi have to be paid and this may we eave consumers with ess money to spend on goods and services. Rising househod debt threatens recovery Boated eves of househod debt threaten to dampen Canada s economic rebound as consumers focus on paying their bis rather than spending freey. Househod debt has more than doubed from 1989 eves and now stands at a record $1 triion or $1.47 for every doar of disposabe income. With the Bank of Canada expected to raise interest rates, perhaps as eary as next week, vunerabe Canadians coud soon find themseves emptying their pockets to cover higher interest payments. The high rate of househod indebtedness is a source of risk [to the Canadian economy], the Organization for Economic Co-operation and Deveopment cautioned in a report on Wednesday. The combination of higher interest rates and arge amounts of debt coud reduce consumer spending a cornerstone of the Canadian economy and an essentia component of the country s recovery from the recession. High eves of debt aso eave consumers financiay vunerabe if they fa i or ose their jobs. Many Canadians are very concerned about their finances. One physiotherapist in Ottawa spends 5 per cent of her income to pay back the credit card debt and student oans she accumuated whie buiding her business and is aready feeing short on cash. Even a sma boost in interest rates woud force her to revisit her pans to attend schoo to become a chiropractor. It reay sucks that I had to spend a ot of money to get set up and now I m kind of trapped in a cage if rates go up too much, she said. I ve aready cut back on expenses I don t buy fancy cothes, I don t eat out. I don t want to be in a situation where these debts are just impossibe to pay off. Source: Adapted from The Gobe and Mai, Thursday May 26, 21 Student workpoint 14.3 Read the short text beow and answer the questions that foow. Use the data from the text to support your answers. Mexico s Consumer Confidence on the Rise Consumer confidence among Mexicans rose in June to its highest eve since prior to the goba economic crisis in 28, the Nationa Statistics Institute said Monday. The June (21) survey put consumer confidence at 87.5 points versus 84.6 points in May, said the institute. The index was at 81 points in June 29. It reached its owest eve of 77 points in October 29. The survey consists of five questions: two about the househod financia situation, two concerning the overa economy in the present and future and one question concerning consumers abiity to purchase durabe goods. 1 Using numbers from the text, expain the difference in consumer confidence in Mexico from: a May 21 to June 21 b June 29 to June 21 c June 29 to October 29 d 28 to 21 (approximatey). In June 29 Mexico was at the ow of the recession, in which gross domestic product dipped 1% at its weakest point. The economy was aso bady hurt by the outbreak of the A/H1N1 infuenza virus, which scared off tourists and caused authorities to cose restaurants, cubs and other pubic venues in some cities. GDP began its recovery ate in the second quarter of 29 and showed its first year-on-year growth in the first quarter of this year (21), rising 4.3%. Whie consumer confidence has shown an overa gain in the ast eight months, it remains beow the eves of 28, when it started the year above 1. 2 Why do you think that the Mexican survey asks a separate question about consumers wiingness to buy durabe goods. Use a definition of durabe goods in your answer. 3 Using a diagram, expain how the change in consumer confidence from 29 to 21 might be expected to affect Mexican AD. 4 Suggest reasons for the change in consumer confidence from 29 to 21. Student workpoint 14.4 Be an inquirer Consumption makes up most of the aggregate demand in most countries. Consider the nationa income data in workpoint 13.1 and note the percentage of aggregate demand that comes from consumption in Canada. You wi find that this is rather typica of the deveoped countries. Investigate the distribution of AD for the country that you chose in workpoint Labour Minister Javier Lozano recenty said that the forma abour market over the past year has recovered amost to pre-crisis eves. During the crisis many peope sought work in the informa economy, such as seing goods on the street, which tends to give them ess job security and therefore ess consumer confidence. With this improvement in the forma abour market some optimism is returning. The entire word economy rests on the consumer; if he ever stops spending money he doesn t have on things he doesn t need we re done for. Bi Bonner

4 What causes changes in investment? Interest rates In order to invest, firms need money. The money that firms use for investment comes from severa sources. For exampe, they can use their retained profits or they can borrow the money. Both of these are affected by the interest rate. If the money is to be borrowed, then an increase in the cost of borrowing may ead to a fa in investment. If interest rates are high, then firms may prefer to put their retained profits in the bank to earn higher returns as savings, rather than use them to invest. Therefore there is an inverse reationship between interest rates and the eve of investment, as shown in Figure A decrease in the interest rate, from 7% to 4%, wi decrease the incentive to save and decrease the cost of borrowing, so is ikey to ead to an increase in borrowing that is ikey to resut in an increase in the eve of investment from I 1 to I 2. An increase in the interest rate wi have the opposite effect. Changes in the eve of nationa income As nationa income rises this eads to an increase in consumption, as discussed above. If nationa income and consumption are rising rapidy there wi be pressure on the existing capacity of firms. This is ikey to encourage firms to invest in new pant and equipment to meet the increase in demand. This is what we refer to as induced investment. We say that investment acceerates when nationa income rises. Technoogica change In any dynamic economy there is ikey to be a quick pace of technoogica change. In order to keep up with advances in technoogy and to remain competitive firms wi need to invest. Expectations/business confidence Businesses make decisions about the amount of investment they shoud make based to a arge extent on their expectations for the future and their confidence in the economic cimate. There woud be itte point in investing to increase the potentia output of a firm if consumer demand is ikey to fa in the future. If businesses are very confident about the future of the economy and expect consumer demand to rise then they wi want to be ready to meet the increases in consumer demand by investing to increase potentia output and productivity. Economists reguary measure the confidence of businesses and pubish data in the form of a business confidence index. Interest rate (i) 7% 4% Leve of investment Figure 14.4 The reationship between investment and the interest rate To meet the growing demand for cars in a booming economy, firms may need to invest in factories and transportation faciities I1 I2 I Student workpoint 14.5 Read the foowing artice adapted from The Financia Times and answer the questions that foow: German business sentiment at three-year high A remarkabe upturn in German economic sentiment was confirmed on Friday by a surge in business confidence, which reached the highest eve for three years in Juy, as empoyers reported a steady recovery in order books and cuts in the numbers on short-time working. The business cimate index produced by the Munich-based Ifo institute rose to 16.2, from a eve of 11.8 in June, the sharpest increase recorded since German unification in 199. The German economy is in a party mood, said the president of the Ifo institute. The monthy survey of 7, German business executives reported expectations for the coming haf year were aso more optimistic than in June, contrary to genera concern about a renewed economic sowdown. In manufacturing, the business outook has brightened strongy, said Professor Sinn, with improved capacity utiisation of pant and machinery, and export opportunities seen to be as positive as in June. Firms empoyment pans are more favourabe and point towards sight increases in staff eves. The export-ed recovery of the German economy aso seems to be spreading graduay into the domestic economy with whoesae, retai and construction sectors a refecting the improved business cimate. These are fantastic numbers, said Andreas Scheuere of Deka 1 With reference to the graph, state the extent of the increase in business confidence since the worst of the recession in ate 28-eary Outine the reasons for the improvement. 3 Use a diagram to show how the change in business expectations might infuence aggregate demand. What causes changes in government spending? The amount and nature of government spending depends on a vast range of factors and the goas of the government. For exampe, we ooked at government subsidies in Chapter 5. If the government has made a commitment to financiay support a given industry, then government spending wi rise. If governments are obiged to spend to correct market faiure, then government spending wi rise. A new education or heath poicy might require increased pubic spending on schoos or hospitas. We ook at government poicies to affect AD shorty German business cimate Ifo index (2=1) 8 Jan Ju 21 bank. It s incredibe what is going on. He said that there were reports of some German factories shortening summer hoiday breaks to dea with growing demand. Source: Adapted from The Financia Times, Juy 23, 21 (author Quentin Pee) 176 What causes changes in net exports? Exports Exports are goods or services that are bought by foreigners. If foreign incomes rise then their consumption of imported goods and services 177

5 wi rise. For exampe, as the Chinese nationa income rises, Chinese peope are more wiing and abe to buy imported goods and services from Europe. Thus, European exports rise as the Chinese economy grows. Simiary, as China grows, investment in China expands. This is ikey to invove some measure of imported capita. Thus, as China grows, German exports of capita equipment may aso rise. The type of trade poicies that a country adopts wi affect its eve of import spending. If a country decides to adopt a more iberaised trade poicy by, say, reducing tariffs (taxes) on imports, then import expenditure woud be expected to rise. However, if a more protectionist set of poicies were to be adopted then import expenditure woud fa, ceteris paribus. 178 Other than changes in the nationa income of trading partners, changes in the vaue of a country s currency (its exchange rate) can aso affect a country s exports. If a country s exchange rate becomes stronger, then this makes the country s exports reativey more expensive to foreigners. According to the aw of demand, this wi cause the quantity of exports to fa. This wi have an effect on the country s export revenues (the way in which it affects the export revenues depends on the easticity of demand for exports; this wi be addressed in a ater chapter). Conversey, if the exchange rate fas in vaue then exports wi become more competitive and may resut in an increase in export revenues. Changes in countries trade poicies may aso affect the vaue of a country s exports. If a country decides to adopt a poicy of more iberaized (free) trade then it may reduce the tariffs that it charges on imports and effectivey aows countries to export more to that country. On the other hand, if a country adopts more protectionist poicies to reduce the eve of imports then it wi reduce the exports of other countries. The ast broad factor to affect export revenues is the reative infation rates among trading partners. For exampe, if infation in the US were reativey higher than in Canada then US goods woud be ess competitive in Canada and may reduce the export revenues which the US earns from its exports to Canada. On the other hand, if the infation rate in the US were reativey ower than the Canadian rate then American goods woud be more competitive in Canadian markets, and so American export revenues might be expected to rise, ceteris paribus. Imports It has aready been estabished that when a country s nationa income is growing there is ikey to be an increase in consumption. As peope consume more goods and services it wi necessariy be the case that some of these goods and services wi be imported. Simiary, as nationa income rises there is ikey to be greater investment. Part of the capita goods that are purchased wi be imported capita goods and/or components. Thus, as nationa income rises so does spending on imports. If nationa income fas there wi be reduced spending on imports. Using the same anaysis as we used above, you shoud be abe to see how changes in a country s exchange rate woud be expected to change the eve of spending on imports. An increase in the exchange rate woud make imported goods ess expensive and, depending on the easticity of demand for imports, coud reduce import expenditure. A decrease in the exchange rate woud make imported goods more expensive and thus affect the eve of import expenditure. If the infation rates of trade partners were to vary notaby then this might aso affect the eve of import spending as noted above. Thus, net exports (the difference between export revenues and import expenditure) depends on domestic nationa income (affecting the demand for imports), foreign nationa incomes (affecting the demand for exports), changes in exchange rates, changes in trade poicies, and reative infation rates. We spend much more time discussing changes in trade poicies and exchange rates in ater chapters. Student workpoint 14.6 Be knowedgeabe Situation favourabe in Germany, but the outook is not bright 1 Define the foowing terms identified in bod in the text: a GDP b Aggregate demand. For years Germany agged the rest of the eurozone, says Wirtschaftswoche. Now we re eading it. Anaysts reckon that German GDP grew by up to 1.5% in the second quarter aone. That s an annuaised rate of 6% twice the figure expected for America this year. The rebound in aggregate demand is being driven by exports, which account for a comparativey hefty 4% of GDP. They jumped by 9.2% month-on-month in May, an annua rate of 22.9%, the strongest growth since the eary 199s. IHS Goba Insight expects exports to cimb by 1% this year, compared to 6% 7% in other major European economies. Germany s high-end capita goods are especiay soughtafter in booming emerging economies. There, Germany has a stronger presence than its European rivas. With exports and now domestic investment picking up, the abour market is improving. The unempoyment rate is at an 18-month ow of 7.7%. The missing piece of the puzze is consumption. So far, at east, househods have shown itte incination to open their waets. Retai saes are sti 2.4% beow ast year s recession-hit eves. Consumer confidence is aso under its ong-term average. Wage growth is aso sow, due to the previous rise in unempoyment, and fisca tightening is on the way next year. Given a that, anaysts 2 Expain why Germany s high-end capita goods are especiay sought-after in booming emerging economies? 3 Using information from the text, try to expain changes to any of the components of AD. argue that the outook for consumer spending is not encouraging. Domestic demand is the Achies hee of the German recovery, says one anayst. The troube is that the goba outook is deteriorating as company restocking sows and government fisca stimuus programmes fade. The deepening mess in the eurozone periphery doesn t hep either. The eurozone sti accounts for 45% of Germany s exports. The German economy is highy geared to goba growth. And with growth everywhere sowing, it ooks ikey to strugge over the next few months. Source: Adapted from Money Week, Juy 16,

6 18 Government poicies affecting aggregate demand Governments have two broad categories of poicies avaiabe to affect the eve of aggregate demand in the economy. These are known as fisca poicy and monetary poicy. Fisca poicy Fisca poicy is defined as the set of a government s poicies reating to its spending and taxation rates. Direct taxes (taxes on income) and indirect taxes (taxes on goods and services) can be raised or owered to ater the amount of disposabe income consumers have. Governments use expansionary fisca poicy to increase aggregate demand and contractionary, or defationary, fisca poicy to reduce aggregate demand. Expansionary fisca poicy If a government woud ike to encourage greater consumption, then it can ower income taxes to increase disposabe income. This is ikey to increase AD. If a government woud ike to encourage greater investment, then it can ower corporate taxes so that firms enjoy higher after-tax profits that can be used for investment. This is ikey to increase AD. Governments have major investment projects themseves and may increase their spending in order to improve or increase pubic services. This directy impacts upon AD. The government budget When we refer to government or pubic spending, we are speaking about the tota spending by a eves of government in a country, incuding the centra (e.g. federa or nationa) government, regiona (e.g. state or provincia) governments, and oca (municipa) governments. Broady speaking, there are three categories of pubic spending. Capita expenditures incude any spending that adds to the capita stock of the economy, such as the spending on the up-grading of a nationa highway or the buiding of schoos and hospitas. Current expenditure tends to be on-going spending such as the purchases of textbooks in schoos or the payment of wages to pubic sector empoyees. The ast category is transfer payments, which incude any benefits paid to peope in the economy for which no goods and services are produced in return. These incude payments such as unempoyment benefits, chid support payments, disabiity payments, and pensions. Governments receive their income from different sources. These incude the payment of income taxes and socia security payments by househods, socia security payments and corporate taxes by firms, indirect taxes paid on expenditure on goods and services, and tariffs paid on the purchase of imported products. Other than income from taxes, governments aso earn money Theory of Knowedge In this chapter you have read two artices about the German economy. The artices were written within one week and they come from different sources. The artices are not competey contradictory, but they do highight different views about the prospects for the German economy. Why do you think that the artices present these different views? What does this te you about the nature of knowedge in economics? from the profits of government-owned (nationaized) businesses or if they se nationaized industries. Income is aso earned when governments rent out government-owned buidings or and. Each year governments issue their nationa budgets, where they ay out their expected spending and revenues for the coming year. This is known as the fisca stance. If they expect to earn more than they spend it is caed a budget surpus. If they pan to spend more than they earn it is a budget deficit and if expected revenues are equa to expenditures then it is a baanced budget. To finance a budget deficit (or to run a budget deficit ) the government wi have to borrow money, either from the househods and firms within the country or by borrowing from abroad. The government does this by seing government bonds. Peope buy the bonds as a form of saving; they end money to the government and are eventuay paid back, aong with extra payment which is the interest paid by the government. When a government runs a deficit in one year this is added to the tota debt accumuated by the government. Therefore, in any given budget, the government has to aocate some money to paying back the oans and the interest on the oans taken in the past. If a government has a budget surpus in a given year this can be used to pay back the government debt. Monetary poicy Monetary poicy is defined as the set of officia poicies governing the suppy of money in the economy and the eve of interest rates in an economy. The eve of money suppy in an economy is an advanced topic that is not deat with in the IB Dipoma Programme syabus. However, you must be aware of how changes in interest rates can affect the eve of AD in an economy. In any economy, there is a vast array of different interest rates. Advertisements offering ow mortgage rates or competitive financing are exampes of the interest rates offered by private profitmaking businesses such as commercia banks. Athough banks are reguated by the government, they are mainy free to set these rates themseves. When we tak about interest rates as a too of monetary poicy we are taking about the base rate (or discount rate or prime rate) that is set by a country s centra bank. The centra bank is not a private profit-making bank but is essentiay the government s bank and the utimate authority in contro of the money suppy in an economy. In some countries the government contros the centra bank, but in most industriaized countries these days the centra bank is an independent body with the primary responsibiity of maintaining a ow and stabe rate of infation in the economy. Changes in the centra bank s base rate utimatey impact upon a borrowing and ending in the economy and are an important signa of a country s monetary poicy. Even though the centra bank may be argey independent we usuay consider its activities as part of government monetary poicy. Changes in the centra bank s base rate can affect the eve of AD in the economy. To increase aggregate demand the centra bank might ower the base rate. This utimatey reduces the cost of borrowing and can ead to increases in both consumption and investment. This woud be known as expansionary or oose monetary poicy. To operate a contractionary or tight monetary poicy to reduce aggregate demand, the centra bank woud increase the base rate. Examination questions Paper 1, part (a) questions 1 Using a diagram, expain the differences between an increase in demand and an increase in aggregate demand. 2 Expain three factors that coud cause an increase in the eve of consumption in an economy. 3 Using a diagram, expain how the government can use fisca poicy to ater the eve of AD in the economy. 4 Using a diagram, expain how a change in interest rates is ikey to affect the eve of investment in an economy. [1 marks] [1 marks] [1 marks] [1 marks] Assessment advice: anaysis and evauation We wi save questions that invove more anaysis and evauation unti we have taken the vita step of ooking at the interaction between aggregate demand and aggregate suppy. Student workpoint 14.7 Expain the eements that woud be incuded in a contractionary fisca poicy. Iustrate the effects of a contractionary fisca poicy on AD. Student workpoint 14.8 Draw an aggregate demand diagram to iustrate an increase in AD, and one that shows a decrease in AD. Be sure to abe the axes accuratey. Decide whether each of the foowing factors woud ead to an increase or a decrease in AD and write out the point beneath the appropriate diagram. In each expanation, expain which component(s) of AD is ikey to be affected and why. Exampe: A fa in income tax is ikey to ead to an increase in AD because consumers disposabe incomes wi rise, eading to an increase in consumption, ceteris paribus. 1 a fa in house prices 2 a rise in consumer confidence 3 an increase in foreign incomes 4 a fa in the consumer confidence index 5 a decrease in interest rates. 181

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