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What is aggregate demand? Explain what determines the main components of aggregate demand?

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Introduction

What is aggregate demand? Explain what determines the main components of aggregate demand? Aggregate Demand can be defined as the total level of demand within an economy. It is also referred to aggregate monetary demand. To calculate aggregate monetary demand we use the equation: AMD=C+I+G+(X-M) Where: C: Consumer expenditure I: Planned fixed capital formation by firms G: Government expenditure X: Expenditure by foreign countries on UK goods (exports) M: Expenditure by the UK on foreign goods (imports) The curve of AMD looks as follows: In order to determine the value of AMD we need to look further into the components of AMD. Consumer expenditure is the most important component of aggregate demand. It is the amount of money spent by individuals and households on food, clothing, technologogiacal, housing, travel, leisure, entertainment and any other expenditure an individual makes. A key determinant of consumer spending is disposable income. It is plain to see that as disposable income rises so will general spending. ...read more.

Middle

houses, cars and furniture. Another way in which price level affects consumption levels is through the wealth effect. A rise in the price level leads to the real value of a consumer's wealth being less then it was previously. Hence a sum of value will be worth less if interest levels rise by 10-20% over the year. A fall in real wealth will result in a fall in consumer spending. We can see that there is an inverse relationship between interest rates and consumer spending. As interest rates rise, consumer spending falls leading to an outward shift of the AD curve and as interest rates lower consumer-spending increases leading to an inward shift of the AD curve. Planned fixed capital formation by firms is also known as investment. Investment is affected by changes in the rate of interest. The higher the rate of interest, the less profitable new investment projects become and therefore the firm will undertake fewer projects and improvements as well as expansions. ...read more.

Conclusion

The values for government spending G does not include payments were there is no corresponding output in the economy e.g. welfare payments and grants. Government spending does little to shift the AD curve. Imports and Exports contribute heavily to AMD. A higher price level in the UK mans that foreign firms will be able to compete more successfully in the UK economy. If typewriter manufacturers were to raise their prices by 12% in the UK and foreign typewriter manufacturers kept their prices same, then British typewriter manufacturers would become less competitive and more foreign typewriters would be imported. Using the same theory British typewriter manufacturers would find it harder to export their product. Hence a high UK price compared to foreign prices will lead to a fall in UK exports and a rise in foreign imports. To conclude we can say that aggregate demand falls as price rises, firstly due to the fact that increase in interest rates reduce consumption and investment. Secondly, because a loss of international competitiveness at the new higher prices will reduce exports and increase imports. Riyaz Dhalla Economics Essay: 2a Dr. Wigley -1/3- ...read more.

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