Shifts in the AD curve: Demand –side policies
The AD curve as we know shows the relationship between aggregate expenditure and
price level, when other things are constant. However the AD curve frequently shifts due
to changes in various factors:
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Government policies
Foreign income changes
Expectations
External shocks
Demand side policies:
The government plays a huge role in controlling the economy and can use various polices
to influence Aggregate Demand in the economy. Two of these policies are discussed
below. They can be used in isolation or in conjunction with a broader government
strategy to change the spending patterns of households, businesses and the foreign sector.
1. Fiscal Policy:
Fiscal Policy is an instrument of DEMAND MANAGEMENT which seeks to
control the level of economic activity in an economy through the control of
TAXATION and GOVERNMENT EXPENDITURE.
Quite simply, if a government spends more, without increasing taxes, then aggregate
demand increases. For example, if the government spends more on defence then
government purchases will increase on military goods and more people will be employed
either directly or indirectly.
If the government reduces taxes (e.g. income tax, corporation tax) or increases transfer
payments (pensions, unemployment benefit etc) without reducing its own spending, then
aggregate demand will increase. Reduced taxes and increased spending increase people’s
________________________- they have more money in their pockets to spend- see UK
budget changes.
2. Monetary Policy
Monetary Policy is a tool of MACROECONOMIC POLICY which involves the
regulation of the MONEY SUPPLY, CREDIT and INTEREST RATES in order to
control the level of expenditure in an economy.
The money supply is determined by the Central Bank within a country- this is the
government’s bank. Its most basic measurement is the value of notes and coins in
circulation. The greater the quantity of money supplied, the greater will be aggregate
demand. An increase in the quantity of money leads to people spending some of the
increase on more goods and services.
Interest rates affect household spending on consumer durables, investment spending and
saving. If the Central Bank raises interest rates, it increases the cost of borrowing money
and thus consumer durable spending will fall, investment spending will fall and saving
becomes more attractive. The Central Bank can also loosen or tighten restrictions on the
availability of credit (borrowing money).
Other factors:
1. Foreign Income Changes:
Aggregate demand can increase because exports increase. The major determinant of
export demand is the income of foreigners. Increased Chinese mainland prosperity
should alone cause more Chinese citizens to come to Hong Kong as tourists. (Chinese
tourists in HK are an export for HK but an import for China). This therefore increases
the demand for hotel rooms, luxury goods, restaurant meals etc.
The exchange rate is another international factor which can alter aggregate demand. The
exports of a country become more attractive the cheaper its currency, that is, the lower
it’s exchange rate. An weakening Euro means that Eurozone exports should, in theory
become cheaper outside the Eurozone thus increasing the demand for German or Greek
exports and therefore Germany/Greece aggregate demand.
2. Expectations:
Expectations about the future affect spending decisions of both consumers and
businesses. If inflation is expected to rise in the future, consumers and businesses may
well increase present purchases. If inflation is expected to fall, then expenditure may be
delayed.
Business expectations about the future have huge implications on their investment
decisions. If businesses feel optimistic about future sales and profitability they may well
increase investment expenditure. Pessimism will decrease investment and aggregate
demand will fall.
3. External Shocks
Aggregate demand may increase temporarily and then fall back to its previous level.
Such an increase is known as external or, demand side shock.
Exercise:
Show the effect of each of the following changes on China’s Aggregate Demand curve &
state what component(s) of AD each one affects.
1. Chinese government invests $50,000,000 in a railway building programme in
Tibet
2. Terrorists bomb locations in Shanghai & Beijing
3. Central Bank of China restricts the availability of credit to only those own land or
property
4. Central Bank decreases base interest rate from 5% to 3 %.
5. Expected household income levels to rise 20% in real terms over 5 years
6. New taxation bill increases business tax from 13% to 30%