Objective: Demonstrate an understanding of the circular flow of income and factors that may cause shifts in AD. .
1. Circular Flow of Income.
The circular flow of income diagram is critical to understanding how a national economy operates. It is used to show the relationship between changes in aggregate demand and the four macroeconomic objectives. .
Draw the circular flow of income diagram, including all sectors of the model and their corresponding injections and withdrawals/leakages. Write down which of the following are changes in injections and which are changes in withdrawals from the nation's circular flow of income. Assuming ceteris paribus, specify whether the change in each case will reflect an increase or a decrease in aggregate demand. .
a) The government raises tax allowances: changes in the withdrawals, results to a reduction in aggregate demand. .
b) The government cuts spending on infrastructure: changes in the injections, results to a reduction in aggregate demand.
c) Firms borrow more money to expand their production facilities as they anticipate an increase in consumer demand: changes in the injections, results to an increase in aggregate demand. .
d) A depreciation of the exchange rate makes holidays abroad less desirable: changes in the withdrawals, results to a reduction in aggregate demand. .
e) The government has decided to lower interest rates: changes in the injections, results to an increase in aggregate demand. .
f) Other countries begin to recover from a recession: changes in the injections, results to an increase in aggregate demand.
2. Changes in Aggregate Demand .
For each scenario below, explain which AD component will be affected and show how the AD diagram will change as a result of the changing condition stated in the example. How will this affect real GDP and price level?.
a) The Government has Increased the Income Tax Rates on Personal Income.
The scenario will impact the consumption component of aggregate demand as this is most heavily determined by income.