The total amount of goods and services demanded in the economy at a given overall price level and in a given time period. It is represented by the aggregate-demand curve, which describes the relationship between price levels and the quantity of output that firms are willing to provide. Normally there is a negative relationship between aggregate demand and the price level. Also known as "total spending".
Aggregate demand is the demand for the gross domestic product (GDP) of a country, and is represented by this formula: Aggregate Demand (AD) = C + I + G (X-M) C = Consumers' expenditures on goods and services. I = Investment spending by companies on capital goods. G = Government expenditures on publicly provided goods and services. X = Exports of goods and services. M = Imports of goods and services.
Numerical example.
Supposing a country has the following data
50 = C = Consumers' expenditures on goods and services.
60= I = Investment spending by companies on capital goods.
80 = G = Government expenditures on publicly provided goods and services.
20 = X = Exports of goods and services.
10 = M = Imports of goods and services.
AD = C + I + G (X-M) : AD = 50 + 60 + 80 (20 – 10)
Animal Spirits [2]
The term “Animal Spirits” is closely associated with John Maynard Keynes who used it in his 1936 book, The General Theory of Employment Interest and Money to capture the idea that aggregate economic activity might be driven in part by waves of optimism or pessimism: (although Robin Mathews 1984, points out that Keynes would have been aware of its use by David Hume 1739, Part iv, Section vii).
"Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits - a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities."
(The General Theory of Employment Interest and Money, 161-162)
The idea that waves of spontaneous optimism might drive business cycles was not new to Keynes and can be traced at least as far back as Henry Thornton who attributed a central role in his theory of credit to “… that confidence which subsists among commercial men in respect to their mercantile affairs…” (Thornton 1802, p. 75).
Practical Example; What we sometimes now term as 'entrepreneurship' has existed for millennia; from traders on the silk road to the Merchant of Venice, from the developers of the US Railroads to Michael Dell....... all driven by Animal Spirits.
Bank Run[3]
A situation in which numerous bank customers try to withdraw their bank deposits simultaneously and the bank's reserves are not sufficient to cover the withdrawals.
Bank runs are a result of panic.
Numerical example.
Recent event in financial services industry would be Northern Rock. On 13 September 2007, Northern Rock asked the Bank of England, as lender of last resort in the United Kingdom, for a liquidity support facility due to problems in raising funds in the money market to replace maturing money market borrowings.[22] The problems arose from difficulties banks faced over the Summer 2007 in raising funds in the money markets, caused by the subprime crisis in the United States. The bank's assets were always sufficient to cover its liabilities, but it had a liquidity problem because institutional lenders became nervous about lending to mortgage banks following the US sub-prime crisis. Bank of England figures suggest that Northern Rock borrowed £3bn from the Bank of England in the first few days of this crisis. (^ £3bn Lent to Northern Rock, Financial Times, 22 September 2007
Bond [4]
A debt investment in which an investor loans money to an entity (corporate or governmental) that borrows the funds for a defined period of time at a fixed interest rate. Bonds are used by companies, municipalities, states and U.S. and foreign governments to finance a variety of projects and activities. Bonds are commonly referred to as fixed-income securities and are one of the three main asset classes, along with stocks and cash equivalents.
The indebted entity (issuer) issues a bond that states the interest rate (coupon) that will be paid and when the loaned funds (bond principal) are to be returned (maturity date). Interest on bonds is usually paid every six months (semi-annually). The main categories of bonds are corporate bonds, municipal bonds, and U.S. Treasury bonds, notes and bills, which are collectively referred to as simply "Treasuries". Two features of a bond - credit quality and duration - are the principal determinants of a bond's interest rate. Bond maturities range from a 90-day Treasury bill to a 30-year government bond. Corporate and municipals are typically in the three to 10-year range.
Numerical Example
US Treasury Bonds
Maturity Yield
3 Month 2.13
6 Month 2.03
2 Year 1.92
3 Year 1.92
5 Year 2.68
10 Year 3.64
30 Year 4.42
Capital Account [5]
The net result of public and private international investments flowing in and out of a country.
The net results includes foreign direct investment, plus changes in holdings of stocks, bonds, loans, bank accounts, and currencies.
Increase in Foregin ownership of domestic assets – Increase of domestic ownership of foreign assets = foreign Direct Investment + Portfolio Investments + Other Investments.
Numerical example.
Supposing a country has the following data
∆ 30 = Increase in Foregin ownership of domestic assets
-∆ 20 = Increase of domestic ownership of foreign assets
10 = foreign Direct Investment
+5 = Portfolio Investments
+2 = Other Investments.
CA = 17
Debt to GDP ratio [6]
A measure of a country's federal debt in relation to its gross domestic product (GDP). By comparing what a country owes and what it produces, the debt-to-GDP ratio indicates the country's ability to pay back its debt. The ratio is a coverage ratio on a national level
This measure gives an idea of the ability of a country to make future payments on its debt. If a country were unable to pay its debt, it would default, which could cause a panic in the domestic and international markets. The higher the debt-to-GDP ratio, the less likely the country will pay its debt back, and the higher its risk of default.
Numerical Example
Supposing a country has the following data
$100 = Countrys’ federal Debt
$80 = GDP
Ratio = 1.25x
Effective Demand [7]
The effective demand principle states that “in a market economy – and, therefore a monetary economy, where money attend all functions (medium of exchange, unit of account and store of value), in every transaction of buying and selling there is only one autonomous decision: the spending one. In result, every spending determines an income of the same extent. By aggregation, the totality of spending in any given period is always equal and determines the totality of income”
(ref 8) 1) In a given situation of technique, resources and costs, income (both money-income and real income) depends on the volume of employment N.
(2) The relationship between the community's income and what it can be expected to spend on consumption, designated by D1, will depend on the psychological characteristic of the community, which we shall call its propensity to consume. That is to say, consumption will depend on the level of aggregate income and, therefore, on the level of employment N, except when there is some change in the propensity to consume. [p.29]
(3) The amount of labour N which the entrepreneurs decide to employ depends on the sum (D) of two quantities, namely D1, the amount which the community is expected to spend on consumption, and D2, the amount which it is expected to devote to new investment. D is what we have called above the effective demand. D1 + D2 = D = f(N),
Numerical Example
Supposing.
D1 : Consumption = 20
D2 : Investment = 30
20 + 30 = 50
Deflation [8]
Deflation means a decrease in the general price level over a period of time. The general price level comprises the price of wages, consumption goods and services. Deflation is often caused by a decrease in the money supply. When the monetary authority and the banks constrict the money supply, deflation is expected to happen. Deflation is considered a problem in a modern economy because of the potential of a deflation spiral and its association with the depression.
Practical example; Japan suffered from deflation in the 1990's; this was perhaps a consequence of the inflation of the late 1980's, which led to an over-heated economy which ultimately "blew-up". The Japanese ecenomy has still not recovered fully from this cycle.
Consumption Function [9]
According to the theory developed by Keynes, the consumption function calculates the amount of total consumption in an economy which consists of two parts: (1) autonomous consumption that is not influenced by current income; (2) induced consumption that is influenced by the economy’s income level. The simple consumption function is expressed as the linear function:
C=C0+C1*Yd
Where C means the total consumption, C0 means the autonomous consumption (C0> 0), C1 means the marginal propensity to consume (0 < name="OLE_LINK1">Consumer Price Index [10]
A consumer price index (CPI) is an index number measuring the average price of consumer goods and services purchased by households. There are two important factors referring calculating the CPI: price data and weighting data. The price data are collected for a sample of goods and services from a sample of sales outlets in a sample of locations for a sample of times. The weighting data are estimates of the shares of the different types of expenditure as fractions of the total expenditure covered by the index. CPI is usually computed monthly as a weighted average of sub-indices for different components of consumer expenditure, such as food, housing, clothing, each of which is in turn a weighted average of sub-sub-indices.
Numerical Example; take the example of Shanghai city, which is one of the biggest cities in China. The monthly CPIs of Shanghai in the year 2007 are shown in the following chart. The benchmark is the monthly CPI in the same month last year (assume as 100). We can conclude that the average price of consumer goods and services purchased by households has been keeping going up, especially in the late 2007.
January
100.9
February
101.3
March
102.2
April
102.0
May
101.8
June
102.7
July
102.7
August
103.9
September
104.5
October
105.1
Investment Function [11]
The investment function is a summary of the variables that influence the levels of aggregate investments. There are three main factors in deciding the total amount of investment. The function can be formalized as follows:
I=I(r,ΔY, q)
Where r is the real interest rate, Y is the GDP and q is Tobin's q. ΔY and q are positively related to the level of the investment while r is related to the investment in a negative way.
Numerical Example; The investment function will increase as the real interest rate reduces, and vice-versa. Therefore to promote investment and thereby hopefully stave off a recession, the US Federal Reserve has recently reduced the interest rate by a total of 1.25% in two cuts designed to increase the Investment Function.
Fiscal Expansion [12]
Fiscal policy is the use of the government budget to affect an economy. When a country is experiencing a depression, fiscal expansion is a popular tool used by government to fight against the depression. The fiscal expansion will change the aggregate demand for goods and services through one of two channels. First, if the government increases purchases but keeps taxes the same, it increases demand directly. Second, if the government cuts taxes or increases transfer payments, people's disposable income rises, and they will spend more on consumption. This rise in consumption will, in turn, raise aggregate demand. The simultaneous use of cutting taxes and increasing government purchasing will stimulate the aggregate demand into a higher level.
Practical Example; it is considered that the fiscal policies of the Irish Governments of the early 1990s were an important contributor to the development of the Irish Economy into the so-called Celtic Tiger era. Lower income tax rates combined with increased Governmental expenditures gave the economy a kick-start that it needed. Former Finance Minister, now an EU commissioner, Mr. Charley McCreevy, was considered a strong advocate of Fiscal Expansionary Policies.
GDP Deflator [13]
GDP deflator is a measure of the change in prices of all new, domestically produced, final goods and services in an economy. GDP stands for gross domestic product, the total value of all final goods and services produced within that economy during a specified period. In most system of national accounts the GDP deflator measures the difference between the real GDP and the nominal GDP. The formula used to calculate the GDP deflator is as follows:
GDP deflator = Nominal GDP/Real GDP x 100
Dividing the nominal GDP by the GDP deflator and multiplying it by 100 would then give the figure for real GDP, hence deflating the nominal GDP into a real measure.
Numerical Example:
If Nominal GDP for a period is 110, and Real GDP is 105, then the GDP Deflator is 104.76
Imports [14]
An import is any good or commodity, brought into one country from another country in a legitimate fashion, typically for use in trade. Import goods or services are provided to domestic consumers by foreign producers. Import of commercial quantities of goods normally requires involvement of the Customs authorities in both the country of import and the country of export.
Example: Ireland imports many industrial and consumer goods such as cars, machinery, white goods, raw materials/natural resources, etc.
Monetary Contraction [15]
Contractionary monetary policy is monetary policy that seeks to reduce the size of the money supply. In most nations, monetary policy is controlled by either a central bank or a finance ministry. Monetary Contraction is the result of (successful) market operations effected by the central bank (“bankers bank” or “lender of last resort”). Contractionary policy can be implemented by reducing the size of the monetary base. This directly reduces the total amount of money circulating in the economy. A central bank can use open market operations to reduce the monetary base. The central bank would typically sell bonds in exchange for hard currency. When the central bank collects this hard currency payment, it removes that amount of currency from the economy, thus contracting the monetary base. Contractionary policy can also be implemented by requiring banks to hold a higher proportion of their total assets in reserve; by calling in loans to banks (or by reducing the value/volume of such loans); or by raising the base interest rate and/or the discount (bank-to-bank) rate.
Example; The Chinese Fiscal Authorities have in 2006/2007 become more concerned with inflationary pressures and overheating of the financial markets in Shanghai & Shenzen. They therefore orchestrated a monetary contraction policy of repeated rate increases and increased bank reserve requirements, to cool the economy. Chinese banks are now required to have Tier 1 capital of approx 13% of lending; this should assist towards monetary contraction, although continued strong growth in trade surpluses will negate the central bank's efforts.
Nominal GDP [16]
A gross domestic product (GDP) figure that has not been adjusted for inflation. It is also known as "current dollar GDP". It can be misleading when inflation is not accounted for in the GDP figure because the GDP will appear higher than it actually is. The same concept that applies to return on investment (ROI) applies here.
Numerical Example: If you have a 9% ROI and inflation for the year has been 4%, your real rate of return would be 5%. Similarly, if the nominal GDP figure has shot up 8% but inflation has been 5%, the real GDP has only increased 3%.
Propensity to Consume [17]
Propensity to Consume is is the percentage of income spent. To find the percentage of income spent, one needs to divide consumption by income, or C / Y, where C is the amount consumed, and Y is the income. In an economy in which each individual consumer saves lots of money (where Average Propensity to Consume (APC) is low), there is a tendency of people losing their jobs because demand for goods and services will be low. Thus saving as a leakage is an advantage from the savers' point of view, while for the economy as a whole it is a considerable disadvantage. Sometimes, disposable income is used as the denominator instead, so the above formula is restated as C / Y-T, where C is the amount spent, Y is pre-tax income, and T is taxes.
The inverse is the propensity to save. These terms are cornerstones of Keynesian theory, most commonly expressed as APC (as above) and MPC (Marginal Propensity to Consume). MPC refers to the increase in personal consumer spending (consumption) that occurs with an increase in disposable income.
Numerical Example: If you earn an additional €100 per month (or benefit from a similar level of tax cut), and you then decide to spend €60 of this increase in net pay, your Marginal Propensity to Consume is said to be 0.6 (or 60%).
Short Run [18]
In economics, the concept of the short-run refers to the decision-making time frame of a firm in which at least one factor of production is fixed. Costs which are fixed in the short-run have no impact on a firms decisions. For example a firm can raise output by increasing the amount of labour through overtime.
A generic firm can make three changes in the short-run:
Increase production; Decrease production ; Shut down
In the short-run, a profit maximizing firm will:
Increase production if marginal cost is less than price;
Decrease production if marginal cost is greater than price;
Continue producing if average variable cost is less than price, even if average total cost is greater than price;
Shut down if average variable cost is greater than price. Thus, the average variable cost is the largest loss a firm can incur in the short-run.
Numerical Example: If you own a copper mine and you have contracted with a third party to provide mining equipment and transport vehicles for a certain period (say, one year), then for your business, one year is the short run (presuming that you cannot sub-contract those facilities to another buyer during this period). In deciding whether to continue mining when the price of copper drops, it is the variable costs of production for that period that are to be considered. The Short Run period to be considered is the period of one year during which some costs of production are fixed.
Real Exchange Rate [19]
The weighted average of a country's currency relative to an index or basket of other major currencies adjusted for the effects of inflation. The weights are determined by comparing the relative trade balances, in terms of one country's currency, with each other country within the index. This exchange rate is used to determine an individual country's currency value relative to the other major currencies in the index, as adjusted for the effects of inflation.
The nominal exchange rate e is the price in domestic currency of one unit of a foreign currency.
The real exchange rate (RER) is defined as RER = e (P / P *) , where P is the domestic price level and P * the foreign price level. P and P * must have the same arbitrary value in some chosen base year. Hence in the base year, RER = e.
The RER is only a theoretical ideal. In practice, there are many foreign currencies and price level values to take into consideration. Correspondingly, the model calculations become increasingly more complex. Furthermore, the model is based on purchasing power parity (PPP), which implies a constant RER. The empirical determination of a constant RER value could never be realised, due to limitations on data collection. PPP would imply that the RER is the rate at which an organization can trade goods and services of one economy (e.g. country) for those of another. PPP appears to hold only in the long term (3–5 years) when prices eventually correct towards parity.
Numerical Example; if the price of an item (say a bicycle) increases by 5% in Hong Kong, and the Euro simultaneously appreciates 5% against the HKD, then the price of the bike remains constant for someone in Germany. The people in HK, however, still have to deal with the 5% increase in domestic prices. PPP would suggest that the residents of Hong Kong & Germany, respectively, should pay the same amount for the bicycle, so that PPP will cause the actual exchange rate to revert to the Real Rate of Exchange.
Trade Surplus [20]
The difference between a country's imports and its exports is known as its “Balance of Trade”. A country has a trade surplus if it exports more than it imports; the opposite scenario is a trade deficit. Balance of trade is the largest component of a country's balance of payments. Debit items include imports, foreign aid, domestic spending abroad and domestic investments abroad. Credit items include exports, foreign spending in the domestic economy and foreign investments in the domestic economy.
Practical Example; up to the mid-1980's, the USA had a trade surplus with the rest of the world. It's success in exporting manufacturing technologies and making Foreign Direct Investment in lower-cost locations, together with an increasing dependence on foreign-produced oil, has reversed this position such that a trade defecit of up to approx $60Bn per month now occurs. Consequently OPEC countries, China, Japan, Germany, Brazil, Venezuala, Ireland, Korea, and numerous others now have net trade surpluses with the US and the world.
[1] Investopedia.com
[2] http://farmer.sscnet.ucla.edu/NewWeb/JournalArticles/ANIMAL%20SPIRITS.pdf
[3] Investopedia.com
[4] Investopedia.com
[5] Investopedia.com
[6] Investopedia.com
[7]http://www.ie.ufrj.br/revista/pdfs/demanda_efetiva_investimento_e_dinamica_a_atualidade_de_kalecki.pdf ; Retrieved from "http://en.wikipedia.org/wiki/Effective_demand" http://cepa.newschool.edu/het/texts/keynes/chap03.htm#text243
[8] From Wikipedia.com
[9] From Wikipedia.com
[10] From Wikipedia.com
[11] From Wikipedia.com
[12] From Wikipedia.com
[13] From Wikipedia.com
[14] From Wikipedia.com
[15] From Wikipedia.com http://en.wikipedia.org/wiki/Contractionary_monetary_policy#Monetary_Policy_and_Inflation [16] http://www.investopedia.com/ - http://www.investopedia.com/terms/n/nominalgdp.asp [17] http://en.wikipedia.org/wiki/Average_propensity_to_consume & http://www.investopedia.com/terms/m/marginalpropensitytoconsume.asp
[18] http://en.wikipedia.org/wiki/Short-run
[19] http://www.investopedia.com/terms/r/reer.asp & http://en.wikipedia.org/wiki/Real_exchange_rate
[20] http://www.investopedia.com/terms/b/bot.asp
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