However what is important to consider is the MPC or marginal propensity to consume. Which means the proportion any increase in income that is spent on consumption. The general view is that at low levels of living an increase in income is almost definitely spent i.e. consumed. The mpc in this case is very nearly 100%. As a person becomes well of the MPC falls as money is now saved for the future.
Consumer expenditure is influenced by the rate of interest in the economy. When prices increase, consumers and firms need more money to buy the same number of goods and services as before. Hence the demand for money increases. An increase in demand will raise the price of money because consumers are competing to borrow money from the financial institutions i.e. banks, building societies and other lending agencies. A rise in interest rates leads to a fall in consumer consumption on goods, which are primarily bought on credit e.g. 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. Again we can see that there is an inverse relationship between the rate of interest and investment. We can say that the higher the rate of interest, the lower the level of investment leading to an outward shift of the AD curve and the lower the rate of interest the higher the rate of investment leading to an inward shift of the AD curve.
Another factor that can be considered is the expectations for the future. Firms often bas investment on external factors which may affect business well being. Examples could include the possibility of an event taking place in the city in which the event is going to be located for example the Olympics. These expectations are risky and therefore investment due to these external factors may vary dramatically. Thus leading to inward and outward shifts of the AD curve.
Government spending with relation to aggregate monetary demand is assumed to be independent of economic variables. It is assumed to be determined by the political decisions of the government who is in power. Government spending will rely on the party’s views and will also rely heavily on were public opinion wants money to be spent on. 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.
