1.††††† Identify the components of aggregate demand and their determinants.
Aggregate demand is a sum of the pre-arranged expenditures from all macroeconomic subjects on acquisition of eventual products. In the open economy, there are four components of aggregate demand: Consumption (C), Government spending (G), Investment (I), Net exports (X-M). The largest component of aggregate demand is consumption. This component is mentioned with the constituents of aggregate demand and their determinants.
The slope of the AD curve depends on how these components respond to changes in the price. In particular, expenditures on consumption, investment, and net exports rise when the price level falls. A number of explanations have been suggested for why a falling price level increases aggregate expenditures (Schiller 168).
As well as individual demand for concrete products, aggregate demand summarizes the great number of correlations between prices and commodities. The curve aggregate demand has descended character too. However, negative inclination for separate demand curve and curve of aggregate demand is explained by different effects that arise from price variation.
Firstly, the change of prices is noted for a curve of aggregate demand. It means that all prices in a short period go up or down that is caught by a cost-of-living-index or deflator of GDP. In this case, when the middle standard of price changes, then a substitution effect does not take place.
Secondly, at the increase of pricesí standard the nominal returns of all subjects also rise, because prices grow not only in the markets of the finished products but also on the markets of resources.
In order to explain negative inclination for the curve of aggregate demand, a change from standard of prices influences on every constituent of aggregate demand has to be analyzed. A change to the real consumer demand is a wealth effect (effect of the real money balances). A change to the investment demand is an effect of interest rate. A change to a clean export is an effect of the imported purchases. A change to the tax system and middle standard of prices on the public purchasing also has a great effect. The increase from standard point of prices conduces to reduction of the real state demand, at least in a short-term period (Schiller 179).
The same explanation as to the market of concrete commodities applies to external forces that can influence to the national market. These are so-called exogenous variables that are unconnected to the change of standard market prices. The action of such non income factors changes demand that displace the AD curve. Expectations of consumers and investors are among the most important non-income factors.
When a pessimistic mood about the future state of economy in society spreads, aggregate demand grows short at any standard of prices; a curve will be displaced to the left. On the contrary, optimistic expectations for the successful state of affairs in the future will displace a curve to the right. Other factors can be the changes in national economic politics and the world economy.
The increase of the public purchasing and social transfers at other unchanging terms will result in displacement of a curve to the right, and the increase of the tax loading on consumers or businessmen will move a curve to the left. The measures of government in the area of monetary policy that are sent to increase or reduce the amount of money in an economy, as a rule, affect changes in demand and give corresponding displacement of the AD curve.
Changes in the world economy influence aggregate demand through an export constituent. When in a foreign country, which is the basic partner of this country in foreign trade, the period of presentation, the profits of its population increase, people will begin to buy more commodities, including those of foreign manufacturing. For a country-exporter, it means the increase of demand for the exported goods. The size of clean export will grow accordingly, and AD curve will be displaced to the right.
Among other factors that displace the AD curve, it is valuable to mention a demographic factor, degree of populationís debt, degree of profitsí differentiation and others. The change of any cited factors shifts aggregate demand and conduces to the change of equilibrium GDP accordingly.
2. Describe how and why AD shifts occur.
A shift in the AD curve means that at every price level total expenditures have changed. Anything other than the price level that changes the components of aggregate demand will shift the AD curve (see fig.1). This question deals with the role of AD shifts.
Five fundamental shift factors of aggregate demand consist of exchange rate fluctuations, expectations, the distribution of income, foreign income, and government policies. A country is not an island, and the U.S. economic output is closely tied to the income of its major world trading partners.
In the national economy, there are also many external economic forces that change initial equilibrium. The change of equilibrium shows up as cyclic vibrations of the economic system.
Classic school considered that vibrations caused "shocks" of suggestion, but Keynes carried a point that there were factors that influenced aggregate demand. He connected it with the change of investment demand, and also with the change of economic policy of the government. Keynes worked out the instruments of public policy that would help in the overcoming crises and depressions and to soften cyclic vibrations in general.
When the state conducts stimulation fiscal politics, it influences aggregate demand and displaces a curve to the right. An analogical effect with some abolition also arises from the increase of money and devaluation of national currency. In the Keynes cases, expansionist politics of government is able to accelerate the development of economy (Schiller 188).
In a modern period the state, trying to soften cyclic vibrations, can initiate reduction of aggregate demand in a hope to overcome inflation, but in case of the left-side displacement of the AD curve the change of equilibrium acquires features. Reacting to the increase of aggregate demand, prices can grow, but they lost property to go down in condition of decreasing demand. This phenomenon is an analog to the technical mechanism that moves a wheel forward, but does not allow it to retrogress. The reason for such one-sided motion of prices only upwards is a domination of monopolies in all spheres of economy. Aggregate demand grows short, but prices do not go down, that is why equilibrium is set in a point with a less production volume, but with the high prices on the same level.
3. Explain how and when macro failure occurs.
Macroeconomic policy is difficult to conduct because we do not know where the potential output is.† Shifts of aggregate demand can be a cause of macro instability. If aggregate demand is too small or too large, the economy will not attain the goals of price stability or full employment (Schiller 185). This question pays attention to macro failure and macro instability.
Arising "shocks" can be negative (petroleum shocks) and positive (perfection of technology). The first is shown through the sharp falling of production and price advance; the second is considered through sharp increase of production and price-cutting.
Unfavorable shocks can be generated by factors of long-term action, for example, by a price advance on imported energy supply, but they can be a result from the action of short-term factors, such as crop failure or natural calamity.
We can admit that prices on energy supplies, which are imported by a country, grew substantially. It will cause the increase of middle charges, as a result, the short-term curve of †aggregate supply will be displaced to the left. Such change of its location on a chart is the consequence of resource price increase and a reason of commodity price advance. This situation shows evidence of stagflation.
World experience shows that more effective variant for overcoming stagflation and proceeding in a double equilibrium can only be the policy, which sent to reduce middle charges on a size adequate to their increase. The basic elements of such policy can be introductions of temporal state control for prices and salary; a decline of taxes from enterprises and cutback of the budgetary spending; stimulation for savings and investments; bringing foreign investments in a national economy and so on. By means of transfers, taxes and other economic instruments, the state regulates fluctuation in the levels of production, employment and inflation.