Let's Dive into Aggregate Demand (AD)!

Hey everyone! Welcome to your study notes for Aggregate Demand, or AD for short. Don't worry if this sounds like a big, scary topic. We're going to break it down into simple, bite-sized pieces. Think of this as learning about the total spending of an entire economy, like Hong Kong. Understanding AD is super important because it helps us see the big picture: why our economy grows, why it sometimes slows down, and what the government can do about it. Ready? Let's get started!


What Exactly is Aggregate Demand (AD)?

In simple terms, Aggregate Demand (AD) is the total amount of goods and services produced within an economy (we call this 'real GDP') that everyone is willing and able to buy at different price levels.

Imagine you could add up all the spending in Hong Kong in a year - from every person buying bubble tea, every company buying new computers, the government building a new park, and even people overseas buying things made in HK. That's basically AD!

We can represent this with a simple formula. You'll see this a lot, so let's make it a friend!

$$AD = C + I + G + NX$$

Let's meet the components:

  • C is for Consumption: This is spending by households (like you and your family) on goods and services. For example: buying movie tickets at Festival Walk, your monthly phone bill, or getting a new pair of sneakers.

  • I is for Investment: This is spending by firms on capital goods. Important: This is NOT about buying stocks and shares! It's about buying things to produce other goods and services. For example: a restaurant buying a new oven, a tech company buying new servers, or a construction firm buying a crane.

  • G is for Government Spending: This is spending by the government on public goods and services. For example: building new hospitals, paying teachers' salaries, or funding infrastructure projects like new MTR lines.

  • NX is for Net Exports: This is the value of exports (goods and services sold to other countries) minus the value of imports (goods and services bought from other countries).
    For example: If HK sells $100 million of electronics to the USA (exports) and buys $80 million of food from Thailand (imports), the Net Exports would be $20 million ($100m - $80m).
Memory Aid!

To remember the formula, just think of the sounds: "C-I-G-NX". Say it a few times and it'll stick!

Key Takeaway

Aggregate Demand (AD) is the total planned spending in an economy, made up of Consumption (C), Investment (I), Government Spending (G), and Net Exports (NX).


Why Does the AD Curve Slope Downwards?

Okay, this is a really important part. The AD curve shows the relationship between the general price level in the economy and the quantity of real GDP demanded.

The relationship is inverse:
- When the overall price level falls, the quantity of goods and services demanded rises.
- When the overall price level rises, the quantity of goods and services demanded falls.

This is why the AD curve slopes downwards from left to right. But why? There are three main reasons you need to know.

1. The Wealth Effect

This is all about purchasing power.
Step 1: Imagine the general price level in Hong Kong falls. Everything gets a bit cheaper.
Step 2: The money you have in your wallet or bank account can now buy more stuff. Your wealth has more purchasing power.
Step 3: You feel richer!
Step 4: Because you feel wealthier, you are likely to spend more. This increases Consumption (C).

Analogy: Think about your Octopus card. It has $150 on it. If the price of a MTR ride, a pineapple bun, and a drink all go down, that $150 feels like it's worth more. You might decide to treat yourself to an extra snack! That's the wealth effect in action.

2. The Interest Rate Effect

This effect connects the price level to investment and consumption.
Step 1: The price level falls.
Step 2: You and others don't need to hold as much cash to buy things. You might save the extra money in a bank.
Step 3: With more funds, banks have more money to lend out. To encourage people and firms to borrow, they lower interest rates.
Step 4: For firms, lower interest rates make it cheaper to borrow money for new projects. So, Investment (I) increases. For households, it's cheaper to borrow for big purchases, so Consumption (C) might also increase.

3. The Exchange Rate Effect

This one is about how our prices affect trade with other countries.
Step 1: The price level in Hong Kong falls.
Step 2: As we saw above, this tends to lead to lower interest rates.
Step 3: Some international investors might move their money out of HK to countries with higher interest rates. To do this, they sell HK dollars, which can cause the HK dollar to become weaker (depreciate).
Step 4: A weaker HK dollar means our exports are now cheaper for foreigners to buy. At the same time, foreign goods (imports) become more expensive for us.
Step 5: Exports go up, and imports go down. This means Net Exports (NX) increase.

Quick Review Box

Why is AD downward sloping?
Wealth Effect: Lower price level → Higher purchasing power → Feel wealthier → More Consumption (C).
Interest Rate Effect: Lower price level → Save more → Lower interest rates → More Investment (I) and Consumption (C).
Exchange Rate Effect: Lower price level → Lower interest rates → Weaker HKD → More Exports, Less Imports → More Net Exports (NX).


Shift of the AD Curve vs. Movement Along the AD Curve

This is a classic spot for confusion, but we can clear it up easily!

A movement ALONG the AD curve is caused ONLY by a change in the general price level. The three effects we just learned (Wealth, Interest Rate, Exchange Rate) all explain movements along the curve.

A SHIFT of the entire AD curve is caused by a change in one of the components (C, I, G, or NX) for a reason OTHER THAN a change in the price level.
- An increase in AD shifts the curve to the right.
- A decrease in AD shifts the curve to the left.

Analogy: Imagine you are on a slide at a playground. Walking up or down the slope of the slide is a "movement along" it. But if a super strong person came and moved the whole slide to a new spot, that would be a "shift".


What Causes the AD Curve to Shift? (Determinants of AD)

Anything (other than the price level) that changes C, I, G, or NX will shift the entire AD curve. Let's look at some examples.

Changes in Consumption (C)

  • Consumer Confidence: If people feel optimistic about the economy and their jobs, they will spend more. AD shifts right. (e.g., The stock market is doing really well).
  • Wealth (Value of Assets): If property prices in HK rise, homeowners feel wealthier and spend more. AD shifts right.
  • Taxes: If the government cuts income taxes, people have more disposable income and will spend more. AD shifts right.
Common Mistake Alert!

Be careful! The Wealth Effect (from a change in the price level) causes a movement along the AD curve. A change in Wealth (from rising stock or property prices) causes a shift of the AD curve. They sound similar but are different!

Changes in Investment (I)

  • Interest Rates: If the central bank lowers interest rates, it becomes cheaper for firms to borrow and invest in new equipment. AD shifts right.
  • Business Confidence (Prospect): If firms are optimistic about future profits, they will invest more today. AD shifts right. (e.g., a new technology is expected to boost sales).

Changes in Government Spending (G)

  • This one is simple! If the government decides to spend more on things like building roads or schools, G increases. AD shifts right.
Did You Know?

When the Hong Kong government gives out consumption vouchers, it is a direct policy to increase Consumption (C) and shift the AD curve to the right to boost the economy!

Changes in Net Exports (NX)

  • Income of Trading Partners: If the economy in Mainland China grows strongly, its citizens and firms will buy more goods and services from Hong Kong. Our exports rise, and AD shifts right.
  • Exchange Rate: If the HK dollar becomes stronger (appreciates) for reasons other than a domestic price level change, our exports become more expensive for foreigners and imports become cheaper for us. Net exports (NX) fall, and AD shifts left.
Key Takeaway

Changes in the price level cause movements ALONG the AD curve. Changes in C, I, G, or NX for any other reason will SHIFT the entire AD curve. An increase in spending shifts it right; a decrease shifts it left.