INDIFFERENCE MAP: A graph of two or more indifference curves. Higher indifference curves are associated with higher levels of utility.
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AGGREGATE DEMAND DETERMINANTS:
An assortment of ceteris paribus factors other than the price level that affect aggregate demand, but which are assumed constant when the aggregate demand curve is constructed. Changes in any of the aggregate demand determinants cause the aggregate demand curve to shift. The specific ceteris paribus factors are commonly grouped by the four, broad expenditure categories--consumption expenditures, investment expenditures, government purchases, and net exports. Aggregate demand determinants are held constant when the aggregate demand curve is constructed. A change in any of these determinants causes a shift of the aggregate demand curve.
The determinants work through the four aggregate expenditure categories--consumption expenditures, investment expenditures, government purchases, and net exports. Should any specific aggregate demand determinant change, it must affect the aggregate demand curve through one of the four aggregate expenditures.
A few of the more notable determinants that tend to stand out in the study of macroeconomics and the analysis of the aggregate market are:
A host of other specific aggregate demand determinants also surface from time to time, including exchange rates between domestic currency and foreign currency, the accumulation of physical wealth especially business capital and household durable goods, and the accumulation of financial wealth especially changes in the value of the stock market.
- Interest Rates: Interest rates affect the cost of borrowing and thus both consumption and investment expenditures. Interest rates are a component of investment-driven business cycles and play a key role in monetary policy.
- Federal Deficit: The federal deficit is comprised of government purchases, which is one of the four basic expenditures, and taxes, which affects the amount of disposable income available for consumption. Changes in the federal deficit commonly result from the use of fiscal policy.
- Expectations: Household and business expectations of future business-cycle conditions, especially inflation and unemployment, affect consumption and investment expenditures.
- Money Supply: The quantity of money circulating in the economy directly affects the buying capabilities of all four sectors and thus affects all four expenditure categories--consumption, investment, government purchases, and net exports. Control of the money supply is the key to monetary policy.
- Consumer Confidence: The degree of household sector optimism or pessimism affects current consumption expenditures.
Shifting the Aggregate Demand Curve
The exhibit to the right presents a standard aggregate demand curve. It is negatively-sloped, capturing the specific one-to-one relationship between the price level and aggregate expenditures. The ceteris paribus factors, that is, the aggregate demand determinants, are assumed to remain constant with the construction of the curve.
|Shifting the Curve
Analogous to other determinants, aggregate demand determinants shift the aggregate demand curve. A change in any of the determinants can either increase or decrease the aggregate demand curve. An increase in aggregate demand is illustrated by a rightward shift in the aggregate demand curve. A decrease in aggregate demand is illustrated by a leftward shift. Click the [Increase in AD] and [Decrease in AD] buttons for a demonstration.
What does it mean to have an increase in demand? It means that for every price level, the four sectors have an increase in aggregate expenditures on real production. A decrease in demand is the exact opposite. For every price level, the four sectors have a decrease in aggregate expenditures on real production.
Four DeterminantsConsider now several specific determinants that work through each of the four broad expenditure categories.
Consumption: Household consumption expenditures, being from a rather large, rather diverse group, are influenced by a lot of things. Here is a short list:
Investment: Investment tends to be the most volatile of the four expenditure categories with a large assortment of influences. The first three determinants listed are comparable to consumption determinants.
- Physical wealth is the material, tangible possessions of the household sector, especially durable goods like cars, furniture, and kitchen appliances. An increase in physical wealth generally reduces consumption expenditures. If consumers have recently purchased a lot of durable goods, then they have less need to buy more, with a subsequent decrease in consumption and aggregate demand.
- Financial wealth is money, stocks, bonds, mutual funds, bank accounts, and other documents that give consumers a claim to goods, resources, or productive assets. When consumers acquire more financial wealth, they tend to spend more freely, with a subsequent increase in consumption and aggregate demand.
- Interest rates are another key consumption determinant. Because interest rates affect the cost of borrowing and because many durable goods are purchased with borrowed funds, higher interest rates reduce consumption and aggregate demand, and lower interest rates do the reverse.
- Expectations of future economic conditions are also an important determinant. Households want to buy at the lowest price possible. If they expect that the price level will rise (that is, they expect rising inflation), then they are inclined to buy more today, causing consumption expenditures and aggregate demand to increase.
Government Purchases: The government sector plays by its own set of rules. In fact, they make the rules. But there is one unavoidable rule that the government sector must follow--when government spends more (or less) on government purchases, aggregate demand increases (or decreases). If elected leaders decide to spend big-bucks on the military, or education, or the space program, or highways, or any number of other worthwhile products, then government purchases increase and so too does aggregate demand.
- Interest rates work much the same for investment as for consumption. Investment expenditures for capital goods are usually financed with borrowed funds. If interest rates change, then the cost of borrowing changes and so too does the overall cost of the investment. Higher interest rates mean less investment and a decrease in aggregate demand.
- Physical wealth possessed by the business sector includes capital goods. This determinant works for investment expenditures much like that for consumption expenditures. In this case the physical wealth is capital, the object of investment. The business sector is less inclined to invest in capital goods, if it has recently accumulated a lot of capital goods through investment. A boost in the amount of capital is bound to cause (eventually) a decline in investment and aggregate demand.
- Expectations of future economic conditions is also an important determinant working through investment expenditures. If the business sector sees an improving economy on the horizon, with expectations of greater sales and profits, they are more inclined to expand investment now, in spite of current conditions. This, of course, boosts aggregate demand.
- Capital prices are another key determinant working through investment. Invoking the basic law of demand, if the price of capital increases, the business sector decreases the quantity of capital demanded. This results in a decrease in investment expenditures and aggregate demand.
- Technology is the last but not the least determinant affecting aggregate demand through investment. Technological advances enhance the need to invest in capital. A new technology requires new capital, different capital, capital to implement the technology. Technological advances invariably trigger an increase investment and aggregate demand.
The specific influences that might entice government to change its spending ways include:
Net Exports: With the inherent diversity of the foreign sector (which includes well over a hundred distinct national governments, almost six billion people, and hundreds of thousands of assorted foreign businesses), a number of things can influence the net-export expenditure contribution to aggregate demand. But here is a handful.
- Fiscal Policy: At the federal level, the desire to counter instability caused by other expenditures though fiscal policy is always a possibility. If aggregate demand decreases because of less spending from the household or business sectors, then the government sector is often inclined to spend more. Alternatively, if aggregate demand increases to the point of triggering inflation, then the government is likely to spend less.
- Politics: Political considerations are almost always bubbling near the surface of government spending. Perhaps the political winds blow in the direction of reducing the federal deficit. Such a force could decrease government purchases and aggregate demand. Or perhaps a rather vocal and financially powerful interest group convinces political leaders to spend more on worthy activities, like the space program, national defense, or environmental quality. This is bound to increase government purchases and aggregate demand.
- State and Local Taxes: At the state and local level, which accounts for about two-thirds of total government purchases, a key determinant is tax collections. A boost in state and local tax collections, which usually happens when the economy is strong, causes state and local government purchases to increase. And when the economy is weak, tax collections fall, and so too do state and local government purchases.
- Global Prosperity: The health of foreign economies is one determinant. When other nations are in fine economic shape, their consumers tend to buy more goods, including more goods produced in the other countries. That means the domestic economy exports more to them and aggregate demand increases.
- Exchange Rates: Currency exchange rates are another determinant of net exports. An exchange rate is the price of one nation's currency in terms of another. When this rate changes, it affects the relative prices of exports and imports. When those relative prices change so too do exports and imports and thus net exports and aggregate demand.
- Trade Barriers: The assortment of trade barriers, tariffs, restrictions, and subsidies that nations tend to use to gain a competitive advantage in the game of foreign trade are also a key determinant. Greater restrictions on imports tend to increase net exports and thus aggregate demand--at least in the short run. In the longer run, other nations tend to retaliate by imposing their own restrictions on the export side and that can reduced aggregate demand.
Two ChangesShifts of the aggregate demand curve, brought about by such things as fiscal or monetary policies, changes in investment expenditures, or changes in consumer confidence, are often the source of disequilibrium in the aggregate market. Such disequilibrium then results in changes in the price level. The key is that aggregate demand determinants CAUSE shifts of the aggregate demand curve which CAUSE disequilibrium which then CAUSES changes in the price level.
This suggests an important difference between two related changes--a change in aggregate demand and a change in aggregate expenditures.
- A change in aggregate demand is any shift of the aggregate demand curve. With this change, the entire curve shifts to a new location. A change in aggregate demand is caused by a change in the aggregate demand determinants. This is comparable to a change in demand in the analysis of the market.
- A change in aggregate expenditures is a movement along a given aggregate demand curve. This change involves the movement from one point on the existing curve to another point on the SAME curve. The curve does not move. A change in aggregate expenditures is caused by a change in the price level, and ONLY a change in the price level! This is comparable to a change in quantity demanded in the analysis of the market.
AGGREGATE DEMAND DETERMINANTS, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2024. [Accessed: February 28, 2024].
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