Factors Responsible for changes in Aggregate Demand

The Aggregate Demand curve shows an inverse relationship between the quantity of goods and services demanded and the price level, other things remaining constant. However, there are several other factors, which might affect aggregate demand apart from the price level. These factors include the level of income, the rate of interest, the exchange rate, expected rate of inflation, government policy, business expectations and so on.

In the long run the changes in aggregate demand cause changes in nominal income only by changing the price level. Because in the long run the level of real income is fixed at the natural rate. Depending on whether the change in aggregate demand is expected or unexpected it may encourage business firms to increase aggregate supply in the short run. But in developing economies like India, the rise in aggregate demand, in many cases, results in spiralling inflation on account of supply bottlenecks and inadequate infrastructural facilities, sometimes demanding stringent monetary controls.

1. A change in Income: This is one of the major factors affecting disposable income and thus, aggregate demand. If institutional change or technological innovation enhances the efficiency of factor inputs and shifts the natural rate of output to a higher level, this implies an increase in aggregate supply in the long run. This, in turn, results in higher level of real incomes to the community, because the higher level of output will provide higher incomes. However, according to monetarists, a rise in nominal income caused by an increase in the money supply will also result in expansion of aggregate demand. If the money supply increases economic agents will be holding increased money balances, and consequently they will increase consumption spending.

2. Rate of Interest: One of the reasons for downward sloping of aggregate demand curve is that as the price level rises the rate of interest will also rise and this in turn will reduce expenditure. As the price level rises, the cost of capital also rises and this will dampen with the decline in expenditure, both consumption and investment spending. The analysis is as follows. Interest rate changes depend on several factors, apart from the changes in price level. When the rate of interest changes and other things including the price level remain constant, this alters the real cost of lending or borrowing. If the rate of interest falls and the price level is constant, firms will be more willing to borrow to finance investment spending and households will be encouraged to borrow to purchase consumer goods. Therefore, the implication is that a decline in rate of interest when price level is constant will lead to an increase in aggregate demand i.e. AD curve shifts upward to the right, and a rise in interest rate when the price level is constant will work as a disincentive to the business firms and finally lead to a fall in aggregate spending or aggregate demand.

3. Government Policy: The changes in the fiscal policy, to a very large extent, can powerfully influence the aggregate demand. It is an established fact that if all other things remain equal an increase in government spending on goods and services imply an outward shift of the aggregate demand schedule. However, an increase in transfer payments or a reduction in taxation of incomes increases disposable income, leading to an increase in consumption spending. All this implies an increase in aggregate demand. The aggregate demand can also be increased, by cutting other taxes such as excise duties, which will result in increased spending power.

In most of the developing countries including India, there is a significant change in fiscal policy in recent years. The emphasis is now more on the effect of government borrowings caused by an excess of spending over revenue from taxation (i.e. a budget deficit which is essentially a revenue deficit) on the money supply. But it is argued particularly that a budget deficit causes an increase in the money supply, and that it is through this way the aggregate demand increases. Whatever may be the case, it is not disputed that a budget deficit will shift the aggregate demand curve outwards. It happens the other way if the government cuts its expenditure and/or raises the rate of taxation.

4. A Change in the Exchange Rate: The changes in the prices of exports and imports are due to the changes in the exchange rate. Particularly the price foreigners pay for exports will fall, if the exchange rate falls and the price for imports paid by the domestic residents will increase.

The result is that, though there has been no change in the domestic price level, exports will increase and imports will fall. This specifically implies that aggregate demand will increase at each and every price level when there is a fall in exchange rate.

The situation is different if the exchange rate rises. The proposition changes with respect to the prices paid by the foreigners and domestic residents for exports and imports respectively. The former have to pay increased prices for their exports and there is fall in the price paid for imports for the latter. Consequently demand for exports will fall while demand for imports will rise although the change in exchange rate will have no direct effect on the domestic price level. This implies that if there is a rise in the exchange rate, there is a fall in aggregate demand at each and every price level.

5. Change in the Expected Rate of Inflation: Any change in the expected rate of inflation will tend to affect aggregate spending, provided that other things remain constant. If the expectation of the economic agents is that there will be a rise in the inflation rate in future, they also expect a fall in the value of their real money balances in future. Acting accordingly they will bring forward many of their spending plans which they are able to. Therefore an increase in the expected rate of inflation is followed by a rise in aggregate demand and a reduction in the expected rate of inflation causes a reduction in aggregate demand.

6. Change in Business Expectations: The investment decisions are highly influenced by the expectations of the future. Confident and optimistic decision takers push up their investment levels expecting a spurt in sales. Therefore the aggregate demand also rises. Conversely there will be a fall in aggregate demand, if the investments are discouraged due to business pessimism.