ACJC Intro to Macroeconomics Annex

ANGLO-CHINESE JUNIOR COLLEGE Economics H1/H2 Introduction to Macroeconomics: Annex 1. Breakdown of Components of AD In the “Introduction to Macroeconomics” lecture notes, the components of AD were introduced in the following equation: AD = C + I + G + (X – M) Where C = Consumer Expenditure, I = Investment Expenditure, G = Government Spending, X = Export Revenue, and M = Import Expenditure. Note that the “M” component above is made up of import expenditure by households, firms, and governments. For example, the consumer’s expenditure can be further broken down as follows: C = CD + CM, where CD = consumption expenditure on domestic goods, and CM = consumer expenditure on imported goods. The same can be applied to investment expenditure and government spending, for example if a firm imports machinery or a government imports sand to reclaim land. This would give us the following breakdown of AD: AD = (CD + CM) + (ID + IM) + (GD + GM) + (X – M) Since M is made up of the total import e xpenditure by all economic agents, this can be shown by: M = CM + IM + GM This gives us the complete AD equation: AD = (CD + CM) + (ID + IM) + (GD + GM) + (X – (CM + IM + GM)) This implies that any change in imports does not directly affect the AD. Take for example a situation where consumer’s demand for imported goods has increased. This would be an increase in C M. Since the C M value applies twice in the equation above, once as a positive and once as a negative value, any increase would be cancelled out and there would be no change in AD. Recall the definition of AD: the total amount of demand for all finished goods and services produced in an economy. Since imports are not produced in an economy, it makes sense that any change in import expenditure would not influence the aggregate demand. Learning point: A change in M has no direct impact on AD

2. Substitution Effect when M changes Although import expenditure has no direct impact on AD, there might be an indirect impact. Using the same example of an increase in demand for imports, let us assume that this increase in demand is due to a change in consumer tastes and preferences. Consumers have switched from consuming domestically produced goods to consuming imported substitutes. How would this affect the AD? Recall the full equation: AD = (CD + CM) + (ID + IM) + (GD + GM) + (X – (CM + IM + GM)) Consumers switching from domestic goods to imported goods would mean an increase in CM and a simultaneous decrease in C D. Mathematically, the increase in C M would be cancelled out, while the decrease in CD would remain, causing a fall in AD through the C component. Thus, the increase in M has led to a decrease in C, decreasing AD. 3. Impact of depreciation of currency on AD One important factor that could affect (X – M) is the exchange rate. Exchange rate changes affect the prices of exports and imports, thus influenci