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Many factors can affect the expected profitability on investment. For example, if the price of energy declines, then investments that use energy as an input will yield higher profits. If government offers special incentives for investment (for example, through the tax code), then investment will look more attractive; conversely, if government removes special investment incentives from the tax code, or increases other business taxes, then investment will look less attractive. As Keynes noted, business investment is the most variable of all the components of aggregate demand.

What determines government spending?

The third component of aggregate demand is spending by federal, state, and local governments. Although the United States is usually thought of as a market economy, government still plays a significant role in the economy. As we discuss in Environmental Protection and Negative Externalities and Positive Externalitites and Public Goods , government provides important public services such as national defense, transportation infrastructure, and education.

Keynes recognized that the government budget offered a powerful tool for influencing aggregate demand. Not only could AD be stimulated by more government spending (or reduced by less government spending), but consumption and investment spending could be influenced by lowering or raising tax rates. Indeed, Keynes concluded that during extreme times like deep recessions, only the government had the power and resources to move aggregate demand.

What determines net exports?

Recall that exports    are products produced domestically and sold abroad while imports    are products produced abroad but purchased domestically. Since aggregate demand is defined as spending on domestic goods and services, export expenditures add to AD, while import expenditures subtract from AD.

Two sets of factors can cause shifts in export and import demand: changes in relative growth rates between countries and changes in relative prices between countries. The level of demand for a nation’s exports tends to be most heavily affected by what is happening in the economies of the countries that would be purchasing those exports. For example, if major importers of American-made products like Canada, Japan, and Germany have recessions, exports of U.S. products to those countries are likely to decline. Conversely, the quantity of a nation’s imports is directly affected by the amount of income in the domestic economy: more income will bring a higher level of imports.

Exports and imports can also be affected by relative prices of goods in domestic and international markets. If U.S. goods are relatively cheaper compared with goods made in other places, perhaps because a group of U.S. producers has mastered certain productivity breakthroughs, then U.S. exports are likely to rise. If U.S. goods become relatively more expensive, perhaps because a change in the exchange rate between the U.S. dollar and other currencies has pushed up the price of inputs to production in the United States, then exports from U.S. producers are likely to decline.

[link] summarizes the reasons given here for changes in aggregate demand.

Determinants of aggregate demand
Reasons for a Decrease in Aggregate Demand Reasons for an Increase in Aggregate Demand
Consumption
  • Rise in taxes
  • Fall in income
  • Rise in interest
  • Desire to save more
  • Decrease in wealth
  • Fall in future expected income
Consumption
  • Decrease in taxes
  • Increase in income
  • Fall in interest rates
  • Desire to save less
  • Rise in wealth
  • Rise in future expected income
Investment
  • Fall in expected rate of return
  • Rise in interest rates
  • Drop in business confidence
Investment
  • Rise in expected rate of return
  • Drop in interest rates
  • Rise in business confidence
Government
  • Reduction in government spending
  • Increase in taxes
Government
  • Increase in government spending
  • Decrease in taxes
Net Exports
  • Decrease in foreign demand
  • Relative price increase of U.S. goods
Net Exports
  • Increase in foreign demand
  • Relative price drop of U.S. goods

Key concepts and summary

Aggregate demand is the sum of four components: consumption, investment, government spending, and net exports. Consumption will change for a number of reasons, including movements in income, taxes, expectations about future income, and changes in wealth levels. Investment will change in response to its expected profitability, which in turn is shaped by expectations about future economic growth, the creation of new technologies, the price of key inputs, and tax incentives for investment. Investment will also change when interest rates rise or fall. Government spending and taxes are determined by political considerations. Exports and imports change according to relative growth rates and prices between two economies.

References

Mahapatra, Lisa. “US Exports To China Have Grown 294% Over The Past Decade.” International Business Times . Last modified July 09, 2013. http://www.ibtimes.com/us-exports-china-have-grown-294-over-past-decade-1338693.

The Conference Board, Inc. “Global Economic Outlook 2014, November 2013.” http://www.conference-board.org/data/globaloutlook.cfm.

Thomas, G. Scott. “Recession claimed 170,000 small businesses in two years.” The Business Journals . Last modified July 24, 2012. http://www.bizjournals.com/bizjournals/on-numbers/scott-thomas/2012/07/recession-claimed-170000-small.html.

United States Department of Labor: Bureau of Labor Statistics. “Top Picks.” http://data.bls.gov/cgi-bin/surveymost?bls.

Questions & Answers

how is the graph works?I don't fully understand
Rezat Reply
multiple choice question
Aster Reply
explain perfect market
Lindiwe Reply
In economics, a perfect market refers to a theoretical construct where all participants have perfect information, goods are homogenous, there are no barriers to entry or exit, and prices are determined solely by supply and demand. It's an idealized model used for analysis,
Ezea
What is ceteris paribus?
Shukri Reply
other things being equal
AI-Robot
When MP₁ becomes negative, TP start to decline. Extuples Suppose that the short-run production function of certain cut-flower firm is given by: Q=4KL-0.6K2 - 0.112 • Where is quantity of cut flower produced, I is labour input and K is fixed capital input (K-5). Determine the average product of lab
Kelo
Extuples Suppose that the short-run production function of certain cut-flower firm is given by: Q=4KL-0.6K2 - 0.112 • Where is quantity of cut flower produced, I is labour input and K is fixed capital input (K-5). Determine the average product of labour (APL) and marginal product of labour (MPL)
Kelo
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Shukri
Can I ask you other question?
Shukri
what is monopoly mean?
Habtamu Reply
What is different between quantity demand and demand?
Shukri Reply
Quantity demanded refers to the specific amount of a good or service that consumers are willing and able to purchase at a give price and within a specific time period. Demand, on the other hand, is a broader concept that encompasses the entire relationship between price and quantity demanded
Ezea
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Shukri
how do you save a country economic situation when it's falling apart
Lilia Reply
what is the difference between economic growth and development
Fiker Reply
Economic growth as an increase in the production and consumption of goods and services within an economy.but Economic development as a broader concept that encompasses not only economic growth but also social & human well being.
Shukri
production function means
Jabir
What do you think is more important to focus on when considering inequality ?
Abdisa Reply
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Awais Reply
sir...I just want to ask one question... Define the term contract curve? if you are free please help me to find this answer 🙏
Asui
it is a curve that we get after connecting the pareto optimal combinations of two consumers after their mutually beneficial trade offs
Awais
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Asui
In economics, the contract curve refers to the set of points in an Edgeworth box diagram where both parties involved in a trade cannot be made better off without making one of them worse off. It represents the Pareto efficient allocations of goods between two individuals or entities, where neither p
Cornelius
In economics, the contract curve refers to the set of points in an Edgeworth box diagram where both parties involved in a trade cannot be made better off without making one of them worse off. It represents the Pareto efficient allocations of goods between two individuals or entities,
Cornelius
Suppose a consumer consuming two commodities X and Y has The following utility function u=X0.4 Y0.6. If the price of the X and Y are 2 and 3 respectively and income Constraint is birr 50. A,Calculate quantities of x and y which maximize utility. B,Calculate value of Lagrange multiplier. C,Calculate quantities of X and Y consumed with a given price. D,alculate optimum level of output .
Feyisa Reply
Answer
Feyisa
c
Jabir
the market for lemon has 10 potential consumers, each having an individual demand curve p=101-10Qi, where p is price in dollar's per cup and Qi is the number of cups demanded per week by the i th consumer.Find the market demand curve using algebra. Draw an individual demand curve and the market dema
Gsbwnw Reply
suppose the production function is given by ( L, K)=L¼K¾.assuming capital is fixed find APL and MPL. consider the following short run production function:Q=6L²-0.4L³ a) find the value of L that maximizes output b)find the value of L that maximizes marginal product
Abdureman
types of unemployment
Yomi Reply
What is the difference between perfect competition and monopolistic competition?
Mohammed
what are y=b+mx
Deva Reply
The equation y = b + mx represents a linear equation in slope-intercept form, where y is the dependent variable, x is the independent variable, m is the slope, and b is the y-intercept. The slope-intercept form of a linear equation is commonly written as y = mx + b, where m represents the slope of
Steven
Consider the following Total Revenue (TR) and Total Cost (TC) functions for a firm operating in a perfect competition market: TR = 6Q and TC = Q3 – 2Q2 + 50Q + 25 Determine the profit maximizing or loss minimizing equilibrium level of output. Compute the level of
Abdulwab Reply

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Source:  OpenStax, Principles of economics. OpenStax CNX. Sep 19, 2014 Download for free at http://legacy.cnx.org/content/col11613/1.11
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