📈 Economics

What are the determinants of aggregate demand in the short and long run?

2 answers
Answered Mar 20Economics
Alyssa's profile picture
Alyssa MillerSeasoned tutor studying Law at Warwick University. Online tutoring available!385 students helped

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. Household consumption expenditures, being from a rather large, rather diverse group, are influenced by a lot of things. Here is a short list: Consumption: 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. 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. 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. 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. The specific influences that might entice government to change its spending ways include: 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. 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. 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.

Answered Jan 19Economics
Michael's profile picture
Michael CombaOxford graduate and experienced tutor.694 students helped

In the short run: Consumption+Investment+Government Spending+Net Exports These are the same in the long run, the difference between the short run and long run only applies to aggregate supply.