Quiz 12: The Aggregate-Demandaggregate-Supply Model


Aggregate demand refers to the total demand for goods and services in an economy. The points on the aggregate demand curve is determined by the following equilibrium conditions • Equilibrium in goods and services market • Equilibrium in money market Aggregate demand curve shows the price and income (output) combinations consistent with goods market and money market equilibriums.

Consumption spending, investment spending, net exports, and government spending are the major components of the market for goods and services. • Consumption Spending: It refers to the demand for consumer goods and services by the people. It depends on consumers' income, wealth, taxes, real interest rate and the consumers' optimism about the future called consumer confidence. Income refers to the yearly earnings whereas wealth is the accumulated assets. Both are directly related to spending. If taxes are high, less income is available for spending. Real interest rate means nominal rate of interest adjusted to inflation. High real interest rate discourages borrowings by the people and encourages them to save. Thus, it reduces spending and demand for goods and services. Hence, real rate of interest is inversely related to spending. • Investment Spending: It refers to the demand for physical capital by business firms. It also includes housing demand by the people. Here physical capital refers to the equipment's and buildings used by the firms in production process. Investment spending depends on anticipations regarding future consumption and the gap between existing capital stock and the desired stock and on financial abilities of the firms. Future consumption depends on real interest rate, income, wealth, and taxes. Financial ability of the form refers to the ability to pay for new capital, which depends on the level of profits and ready availability of loans. Real rate of interest is inversely related to investment. A lower rate of interest increases investment spending. If firms are optimistic about the future, they invest more. • Net Exports: It is the difference between exports and imports. It depends on income levels in home and foreign countries. If people are rich in home country, they consume more of both home and foreign goods and services. If they spend more on foreign goods than domestic goods, net exports will fall. If people in foreign countries are, rich they may import more from the home country and then net exports will increase. • Government Spending: It includes payment to government workers, government purchases of goods and services and government investment. Political authorities decide it. Hence, it is considered as an exogenous variable in the aggregate demand model.

Capital and labor determine the total output in an economy. When they are fully employed or utilized, it is called a situation of full employment. Full employment output is that level of output, which is produced when the economy is in full employment. That is the output produced by fully utilizing labor and capital is called full employment output. However, full employment does not mean a zero unemployment rate. Full employment includes voluntary unemployment and normal rate of job turnover.