Question

4. Determinants of aggregate demand 

The following graph shows a decrease in aggregate demand (AD) in a hypothetical country. Specifically, aggregate demand shifts to the left from AD1 to AD2, causing the quantity of output demanded to fall at all price levels For example, at a price level of 140, output is now $200 billion, where previously it was $300 billion.

 The following table lists several determinants of aggregate demand.

 Complete the table by indicating the change in each determinant necessary to decrease aggregate demand.

Answer 1

1) Decreases

If consumers expect that future profitability is less than they reduce their present consumption which reduces the C component of AD and shifts the AD curve leftward.

2) Decrease

A decrease in government spending decreases the G component of aggregate demand and resulted in the leftward shift of AD curve.

3) Increase

An increase in interest rate reduces investment which leads to decrease in the I component of AD and causes the leftward shift of AD curve.

4) Increase

When the value of domestic currency increases relative to foreign currency then it resulted into increase in imports which reduces the Net Export component of AD and resulted in the leftward shift of AD curve.

Answer 2

Consumption is influenced, in part, by consumer confidence. If households expect strong economic growth and higher earnings, this represents an increase in consumer confidence and consumers will spend more today. The increase in current consumption causes an increase in aggregate demand at each price level.

A decrease in taxes increases households’ disposable income. Households will spend more, causing aggregate demand to increase at each price level.

The rate of return that businesses expect on capital projects is a key determinant of investment. Suppose a technological breakthrough causes an increase in the expected return on investment. Investment spending will rise, and aggregate demand will increase at each price level.

When the value of the domestic currency depreciates against foreign currencies, foreigners will find domestic products less expensive, and citizens of the domestic country will find foreign goods more expensive. The depreciation of the domestic currency causes exports to rise and imports to fall. Because net exports are one component of aggregate demand, this increase in net exports (exports minus imports) causes an increase in aggregate demand at each price level.