HKDSE Notes on Macroeconomics Ch15A Aggregate Demand Page 1 of 26

Chapter 15A Aggregate Demand (AD)

In chapter 13C, we have analyzed how to use expenditure

approach to measure national output (GDP or GNP) of an
economy (ex post). This is national income accounting
(calculation?). It does NOT predict or explain the change in GDP or GNP. In this
sub-chapter, we will shift our focus to national income determination (Why?) (ex
ante).

15.1 Aggregate Demand (AD)

• Aggregate demand (AD) refers to the relationship between the aggregate

output demanded (AQd) and general price levels (P) for a given period of time,
holding other factors constant.
• The aggregate output (Y) of an economy refers to the real output / income, i.e.
real GDP: total market value of final output at constant market prices (Y is NOT
directly measured by the quantities of different goods and services as they cannot
be added together! )
• The general price level (P) is measured by the GDP deflator.

A. Aggregate output demanded (AQd)

• Aggregate output demanded (AQd) refers to the total value of final goods and
services demanded in an economy at a particular general price level over a
specified period.
 HKDSE Notes on Macroeconomics Ch15A Aggregate Demand Page 2 of 26

• Comparing with AD, AQd is a particular value of planned real expenditure on

final products at a particular general price level while AD refers to the
relationship between AQds and the general price levels.

Jargons

‘Aggregate output demanded’ equals ‘quantity of output demanded’. These two

terms can be used interchangeably.

B. AD of an Open Economy and Closed Economy

(a) Open Economy

• An open economy typically consists of FOUR sectors, namely households,

firms, government and the foreign sector. Therefore, the aggregate demand
equals the sum of the demands from these FOUR sectors.

𝑨𝑨𝑨𝑨 = 𝑪𝑪 + 𝑰𝑰 + 𝑮𝑮 + 𝑵𝑵𝑵𝑵

C = Private consumption expenditure (Households’ demand for goods and

services)
I = Gross investment expenditure (Firms' demand for capital goods, say, plant
and machinery)
G = Government consumption expenditure (Government's demand for all
kinds of goods and services)
X = Total exports of goods and services
M = Total imports of goods and services
NX = X – M = Net demand for domestic output from foreign sector
 HKDSE Notes on Macroeconomics Ch15A Aggregate Demand Page 3 of 26

(b) Closed Economy

• For a closed economy, there is NO external trade. Therefore, the aggregate

demand is the total demand for domestic goods and services from three sectors,
namely, households, firms and the government.

𝑨𝑨𝑨𝑨 = 𝑪𝑪 + 𝑰𝑰 + 𝑮𝑮

• If the total exports of goods and services exactly equals total imports of goods
and services, net exports equals zero (NX = 0). The aggregate demands of an
open economy and a closed economy are the same.
 HKDSE Notes on Macroeconomics Ch15A Aggregate Demand Page 4 of 26

15.2 Aggregate Demand Curve

• An aggregate demand curve is a curve showing the aggregate output demanded

at different general price levels for a given period of time, holding other factors
constant.
• It is plotted on an output-price level plane: the x-axis is for the aggregate output
or real GDP (Y) while the Y-axis is for the general price level (P).

Aggregate output demanded is shown by a point on the AD curve while aggregate

demand is represented by the whole AD curve or AD table.

A. The aggregate demand curve is downward sloping to the right

Price level (P)

P1 A

P2 B

AD

0 Y1 Y2 Aggregate output (Y)

• The slope of AD curve is negative.

• At a lower (higher) general price level, the aggregate output demanded will
increase (decrease), keeping other factors constant.
• Increase (decrease) in general price level only brings about upwards (downwards)
movement along the same aggregate demand curve.
 HKDSE Notes on Macroeconomics Ch15A Aggregate Demand Page 5 of 26

B. Why is the aggregate demand curve downward sloping?

The following three effects explain why an exogenous change in general price level
will bring about an endogenous change in aggregate output demanded in an opposite
direction.

(a) (Pigou) Wealth Effect

(i) Definition

• Wealth includes money (cash) and other monetary assets (deposits, shares and
bonds, etc.). These monetary assets are denominated in nominal values.
• The wealth effect refers to the change in the aggregate output demanded brought
about by to a change in wealth caused by a change in the general price level.

(ii) Mechanisms (how it works?) of Wealth Effect

General price level ↓ (↑)

→ Real value or purchasing power of money and other monetary assets ↑(↓)
→ Real wealth of households and firms ↑(↓)
→ Real consumption and investment expenditure ↑(↓)
→ Aggregate output demanded ↑(↓).
 HKDSE Notes on Macroeconomics Ch15A Aggregate Demand Page 6 of 26

Nominal vs Real Private Consumption Expenditure

• ↑(↓) in general price level → ↓(↑) Real private consumption expenditure

• If the percentage increase in general price level outweighs the percentage

decrease in real private consumption expenditure, the nominal private
consumption expenditure can increase with the general price level.

B. (Keynesian) Interest Rate Effect

(i) Definition

• The nominal amount of money supply of an economy does not change with the
general price level.
• Interest rate effect refers to the change in the aggregate output demanded
brought about by a change in the interest rate caused by a change in the general
price level.

(ii) Mechanisms (how it works?) of Interest Rate Effect

• Mechanism 1

General price level ↓ (↑)

→ Households and firms demand less (more) money to finance their transactions
→ Savings ↑(↓) but borrowings ↓(↑)
 HKDSE Notes on Macroeconomics Ch15A Aggregate Demand Page 7 of 26

→ Real interest rate ↓(↑) given the fixed nominal money supply
→ Real consumption and investment ↑(↓)
→ Aggregate output demanded ↑(↓)

• Mechanism 2 (Real money perspective)

Real interest rate (%)

MS1 MS2

ESM
r1

r2

MD

0 Real money balance

𝑀𝑀𝑆𝑆
General price level ↓ (↑) → Real money supply ( ) ↑(↓) → Purchasing power
𝑃𝑃

of the nominal money supply ↑(↓) → Excess supply (excess demand) in the
money market (given no change in real money demand) → Real interest rate ↓(↑)
→ Real consumption and investment ↑(↓) → Aggregate output / Quantity of
output demanded ↑(↓).
 HKDSE Notes on Macroeconomics Ch15A Aggregate Demand Page 8 of 26

• Mechanism 3 (Nominal money perspective)

Nominal interest rate (%)

MS

r1 ESM

r2

MD2 MD1

0 Nominal money balance

General price level ↓ (↑) → Transaction demand for money (in normal terms)
↓(↑) → Total demand for money ↓(↑) → Excess supply (excess demand) in the
money market (given no change in nominal money supply) → Nominal interest
rate ↓(↑) → Real consumption and investment ↑(↓) → Aggregate output /
Quantity of output demanded ↑(↓)

C. Net Exports Effect / (Mundell Fleming) Exchange Rate Effect / International

Price Effect

(i) Definition

• It is assumed that the general price levels of foreign countries do not change with
the domestic price level.
 HKDSE Notes on Macroeconomics Ch15A Aggregate Demand Page 9 of 26

• The net exports effect refers to the change in the aggregate output demanded
brought about by a change in the real exchange rate caused by a change in the
general price level.

(ii) Nominal Exchange Rate vs Real Exchange Rate (for reference ONLY)

• The nominal exchange rate of a currency is the price of it in terms of another

currency.
• For example, the exchange rate of domestic currency (E D ) is defined as the
quantity of foreign dollars (F$) per domestic dollar (D$).

𝐹𝐹$ 𝑈𝑈𝑈𝑈$ 𝑈𝑈𝑈𝑈$1

𝐸𝐸𝐷𝐷 = => 𝐸𝐸𝐻𝐻𝐻𝐻 = = = 0.128
𝐷𝐷$ 𝐻𝐻𝐻𝐻$ 𝐻𝐻𝐻𝐻$7.8

• The exchange rate of foreign currency (E F ) is defined as the quantity of domestic

dollars (D$) per foreign dollar (F$).

𝐷𝐷$ 𝐻𝐻𝐻𝐻$ 𝐻𝐻𝐻𝐻$7.8

𝐸𝐸𝐹𝐹 = => 𝐸𝐸𝑈𝑈𝑈𝑈 = = = 7.8
𝐹𝐹$ 𝑈𝑈𝑈𝑈$ 𝑈𝑈𝑈𝑈$1
• The real exchange rate of the domestic currency is the price of domestic output
relative to that of foreign output.

𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑒𝑒𝑒𝑒𝑒𝑒ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑜𝑜𝑜𝑜 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐

𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁 𝑒𝑒𝑒𝑒𝑒𝑒ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 × 𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙
=
𝑭𝑭𝑭𝑭𝑭𝑭𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙

• Example: Domestic currency D$1 = Foreign currency F$10; Price of domestic

good = D$5; Price of foreign good = F$15

10 × 𝟓𝟓
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑒𝑒𝑒𝑒𝑒𝑒ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑜𝑜𝑜𝑜 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 = = 3.33
𝟏𝟏𝟏𝟏
 HKDSE Notes on Macroeconomics Ch15A Aggregate Demand Page 10 of 26

The opportunity cost of consuming 1 unit of domestic goods is 3.33 units of

foreign goods.

• Example: HK$1 = RMB0.9; Price of Hong Kong good = HK$100; Price of PRC
good = RMB70
0.9 × 𝟏𝟏𝟏𝟏𝟏𝟏
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑒𝑒𝑒𝑒𝑒𝑒ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑜𝑜𝑜𝑜 𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻 𝐾𝐾𝐾𝐾𝐾𝐾𝐾𝐾 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 = = 1.29
𝟕𝟕𝟕𝟕

The opportunity cost of consuming 1 unit of HK goods is 1.29 units of PRC

goods.

Point to note

• In theory, if goods and services are perfectly mobile across countries, the real
exchange rate should be ONE, otherwise arbitrage will emerge.
• In reality, there are non-tradeable goods and positive transaction and
transportation cost, real exchange rate seldom equals ONE.

(iii) Mechanisms (how it works?) of Net Exports Effect

• Mechanism 1

Domestic general price level ↓ (↑)

→ Prices of domestic exports ↓(↑) relative to foreign buyers
→ Prices of imports ↑ (↓) relative to prices of domestic products
→ Volume of exports ↑(↓) while volume of imports ↓(↑)
→ Net exports ↑(↓) if the price-elasticities of demand for exports and/or imports
are sufficiently high
→ Aggregate output demanded ↑(↓)
 HKDSE Notes on Macroeconomics Ch15A Aggregate Demand Page 11 of 26

Mechanism under Flexible Exchange Rate System

Domestic price level ↓(↑) → Interest rate ↓(↑) (interest rate effect) → Net capital
outflow (inflow) → Depreciation (Appreciation) of the domestic currency →
Domestic export prices in foreign currency ↓(↑) while its import prices in domestic
currency ↑(↓) → Volume of exports ↑(↓) while volume of imports ↓(↑) → Net
exports ↑(↓) if the price-elasticities of demand for exports and/or imports are
sufficiently high → Aggregate output demanded ↑(↓)

• Mechanism 2

Domestic general price level ↓ (↑) → Real exchange rate of domestic currency
↓(↑) → the relative price of domestic exports ↓(↑) while the relative price of
imports ↑(↓) → Net exports ↑(↓) if the price-elasticities of demand for exports
and/or imports are sufficiently high → Aggregate output / Quantity of output
demanded ↑(↓).

Points to note

The elaboration of the mechanism above MUST start with ‘When the general price
level (P) decreases / increases’ and end with ‘aggregate output demanded (Y)
increases / decreases’.
 HKDSE Notes on Macroeconomics Ch15A Aggregate Demand Page 12 of 26

Sum up
 HKDSE Notes on Macroeconomics Ch15A Aggregate Demand Page 13 of 26

22.3 Shift of Aggregate Demand Curve

• If price level changes, aggregate output demanded will change. This is

represented by a movement along the same aggregate demand curve.

P↑(↓) → C, I and NX ↓(↑) → Y↓(↑) → Downward (upwards) movement along

the same AD curve

• If factors other than price level changes (?), aggregate output demanded
changes at each and every price level. This is represented by a shift of the whole
aggregate demand curve.
• Aggregate demand consists of consumption expenditure, investment expenditure,
government expenditure and net exports. If one of these expenditure demands
increases (decreases) exogenously (not due to change in price level), the
aggregate demand curve will shift upwards (downwards) and to the right (left)
from AD 1 to AD 2 (AD 3 ).
• Changes in non-price demand determinants → exogenous ↑(↓) in C / I / G /
NX → Y↑(↓) at each and every price level → Rightwards (leftwards) shift of the
whole AD curve

Price level

AD3 AD1 AD2

0 Aggregate output (Y)

 HKDSE Notes on Macroeconomics Ch15A Aggregate Demand Page 14 of 26

A. Shifts of the Aggregate Demand Curve caused by Consumption (C)

When factors other than the price level lead to an increase (decrease) in private
consumption (C), the aggregate demand (AD) curve will shift rightwards (leftwards).

Factors affecting private consumption (Examples)

• ↓(↑) Income tax or ↑(↓) transfer payments / welfare allowance / tax rebate
→ disposable income ↑(↓) → C and AD ↑(↓)

• Optimistic (Pessimistic) economic prospects / Expected economic growth and

recovery (recession) → expected ↑(↓) in future income → C & AD ↑(↓)

• Expected ↑(↓) in general price level → ↑(↓) current consumption to spend

(save) money → C & AD↑(↓)

• ↓(↑) in interest rate → ↓(↑) cost of present consumption → C & AD ↑(↓)

• ↑(↓) in desire / propensity to consume → Proportion of disposable income

used in consumption ↑(↓) → C & AD ↑(↓)

• ↓(↑) in desire / propensity to save → Proportion of disposable income used in

consumption ↑(↓) → C & AD ↑(↓)

• ↑(↓) wealth (drastic ↑/↓ in property / stock prices) → Ability to consume ↑(↓)
→ C & AD ↑(↓)

• Income redistribution from the rich to the poor → relative to the rich, the poor
tends to consume a larger proportion of their disposable income → C & AD↑(↓)

• Expansionary (Contractionary) monetary policy (ch. 20) → ↑(↓) money

supply → ↓(↑) interest rate → ↓(↑) cost of present consumption →C & AD ↑(
↓)
 HKDSE Notes on Macroeconomics Ch15A Aggregate Demand Page 15 of 26

Point to note

As national income is plotted on the horizontal axis of the aggregate demand

diagram, a change in national income (though it changes disposable income) will
only cause a movement along instead of a shift of the aggregate demand curve.

B. Shifts of the aggregate demand curve caused by investment (I)

When factors other than the price level lead to an increase (decrease) in investment
(I), the aggregate demand (AD) curve will shift rightwards (leftwards).

Factors affecting gross investment (Examples)

• ↓(↑) in interest rate → ↓(↑) cost of investment (e.g. purchasing production

equipment) → I & AD ↑(↓)

• Easier (More difficult) financing / ↑(↓) availability of credit → I & AD ↑(↓)

• ↓(↑) profits tax → net profit after tax ↑(↓) → more (less) profitable to invest
→ I and AD ↑(↓)

• Optimistic (Pessimistic) business prospects → expected ↑(↓) in future profits

→ I & AD ↑(↓)

• ↑(↓) in desire / propensity to invest (due to change in investment environment

and government regulations) → I & AD ↑(↓)

• ↓(↑) operating costs of capital decrease → more (less) profitable to invest → I

and AD ↑(↓)

• ↓(↑) business registration fee → I & AD ↑(↓)

• Productivity of factor inputs ↑(↓) → new tools and machinery (e.g. a faster
computer) can ↑(↓) output given the same amount of resources → I & AD ↑(↓)
 HKDSE Notes on Macroeconomics Ch15A Aggregate Demand Page 16 of 26

• Expansionary (Contractionary) monetary policy (ch. 20) → ↑(↓) money

supply → ↓(↑) interest rate → ↓(↑) cost of investment → I & AD ↑(↓)

C. Shifts of the aggregate demand curve caused by government consumption

expenditure (G)

When factors other than the price level lead to an increase (decrease) in government
expenditure (G), the aggregate demand (AD) curve will shift rightwards (leftwards).

Factors affecting government consumption expenditure (Examples)

• Expansionary (contractionary) fiscal policy → G & AD ↑

• ↑(↓) government spending on education → G & AD ↑(↓)

• ↑(↓) government spending on public infrastructure → G & AD ↑(↓)

• ↑(↓) employment of civil servants → G & AD ↑(↓)

Point to note

• Change in government expenditure and / or taxation is closely related to

government budget, expenditure, fiscal policy and goals (ch. 16AFGH)
• Transfer payments increase private consumption through increase in disposable
income but they are not included in government consumption expenditure.

D. Shifts of the aggregate demand curve caused by net exports (NX)

When factors other than the price level lead to an increase (decrease) in net exports
(NX), the aggregate demand (AD) curve will shift rightwards (leftwards).
 HKDSE Notes on Macroeconomics Ch15A Aggregate Demand Page 17 of 26

Factors affecting net exports (Examples)

• Appreciation of domestic currency ( depreciation of foreign currency) → ↓X

while ↑M→ NX & AD ↓
• Appreciation of foreign currency ( depreciation of domestic currency) → ↑X
while ↓M→ NX & AD ↑
• ↑(↓) foreign national income → foreigners consume more (less) domestic
exports → ↑(↓) X → NX & AD ↑(↓)

• ↓(↑) foreign income tax or ↑ foreign welfare allowance → ↑(↓)X → NX&

AD ↑(↓)

• ↑(↓) foreign price level → foreign products become relatively more expensive
(cheaper) → ↑ (↓) X and ↓M → NX & AD ↑(↓)

• ↓(↓) foreign interest rate → ↑(↓) foreign national income → ↑(↓)X → NX&
AD ↑(↓)

• Protectionist policies imposed on imports (e.g. tariff and quota) (ch. 22BC) →
↓M → NX& AD ↑
• Protectionist policies of trading partners imposed on domestic exports (ch.
22BC) → ↓X → NX& AD ↓

• Trade Liberation → ↑X and ↑M → change in NX & AD is dependent on the

relative increase of X and M
• More (Fewer) tourist visiting Hong Kong → ↑(↓)X → NX& AD ↑(↓)
HKDSE Notes on Macroeconomics Ch15A Aggregate Demand Page 18 of 26
 HKDSE Notes on Macroeconomics Ch15A Aggregate Demand Page 19 of 26

Checkpoints

1. If overseas economies keep growing, this will lead to:

(1) an increase in domestic exports.
(2) an increase in net exports.
(3) an increase in the demand for domestic output.

A. (1) and (2) only

B. (1) and (3) only
C. (2) and (3) only
D. (1), (2) and (3)

2. Which of the following changes will not shift the aggregate demand curve?
A. A lower interest rate caused by a lower price level.
B. A lower interest rate caused by a lower money demand.
C. A lower exchange rate.
D. A lower income tax rate.

3. Suppose the government cuts welfare allowances. Which of the following is

correct?
A. A fall in government expenditure shifts the aggregate demand curve
rightward.
B. A fall in government expenditure shifts the aggregate demand curve
leftward.
C. A fall in private consumption expenditure shifts the aggregate demand
curve rightward.
D. A fall in private consumption expenditure shifts the aggregate demand
curve leftward.
 HKDSE Notes on Macroeconomics Ch15A Aggregate Demand Page 20 of 26

4. Which of the following CANNOT explain the downward slope of an aggregate

demand curve?
• When the domestic price level increases, other things being equal, the real value
of net exports decreases. (√ / ×)
• When nominal interest rates increase due to an increase in money supply, other
things being equal, people will consume less and save more. (√ / ×)
• When people’s real wealth increases due to an economic boom, people will
consume more and their real private consumption expenditure increases. (√ / ×)
• When the domestic currency depreciates, the net exports of the domestic
economy increase. (√ / ×)

Learning outcomes

Students are expected to grasp

• the definitions of aggregate demand (AD) and aggregate output demanded

(AQd)
• the FOUR non-price aggregate demand components – C, I, G and NX.
• the wealth effect, the interest rate effect and the exchange rate effect that lead
to the downward sloping feature of an AD curve.
• the factors (examples) that will shift AD function (if the initial source of
change is directly from change in price level (P) or national income (Y), AD
curve will NOT shift).
• private consumption, investment and import expenditures are positively
dependent on income
• that one unit increase in disposable income will induce a less-than-one-unit
increase in consumption expenditure.
 HKDSE Notes on Macroeconomics Ch15A Aggregate Demand Page 21 of 26

Past Exam Questions

A87-7(a)(revised)
Suggest reasons, other than government policy, for shifts of the AD curve. (5 marks)

• increases in uncertainty can shift the investment function

• changes' in population structure can change the saving function

C95-9(c)(i) & (ii)

The World Cup of 1994 was held in the USA. People from all over the world went to
the US to watch the matches.

(i) Name any TWO demand side factors affecting national income. (2 marks)

Any 2 of the following: consumption expenditure, investment expenditure, gov't

expenditure, exports or net exports & imports or net imports

(ii) The holding of the World Cup was favourable to the gross domestic product
(GDP) of the US. Explain this by referring to the TWO demand side factors
you mentioned in (i). (6 marks)

C↑: U.S. residents spent more on food, hotels, travelling and souvenirs
I↑: more hotels and transportation services are built and provided
Net Exports ↑: sales of souvenirs to tourists

C96-12(c)
The government has organised a worker retraining programme for the
unemployed. Explain, with ONE demand side factor and ONE supply side factor,
the effect of such a programme on Hong Kong's GDP. (5 marks)
 HKDSE Notes on Macroeconomics Ch15A Aggregate Demand Page 22 of 26

• Demand-side factor: government expenditure (in current year)

• Supply-side factor: labour productivity ↑ + labour supply (labour with
appropriate skills) ↑
• GDP ↑ in both current and future years

C98-11(c)(i)
In a certain year the sales revenue of Japanese cars in Hong Kong decreased. This
was because the local demand for these cars dropped and the demand for re-export
of these cars to Mainland China also declined.

Explain the effects of the two changes in demand on Hong Kong's GDP. (4 marks)

- With less business, the middleman services / back-up services rendered for the
local demand for Japanese cars dropped in value. Thus the GDP fell.
- Similarly, the middleman services rendered for the re-export demand for
Japanese cars dropped in value. Thus the GDP fell.

C01-11(b)(i)
Suppose the government significantly reduces the stamp duty on the sale of property.
Explain how this would affect investment in the construction industry. (2 marks)

• Demand side: cost of transaction ↓→ incentive to buy property ↑and number of

transaction ↑ (1m)

• Therefore, investment (i) ↑ (1m)

 HKDSE Notes on Macroeconomics Ch15A Aggregate Demand Page 23 of 26

A03-5(b) (revised)
Suppose the corporate accounting scandals (such as the Enron and WorldCom
incidents) in the US have shaken investor confidence. Investors decide to rebalance
their portfolio by shifting away from stocks and corporate bonds into money or
government bonds. As a result, those firms which used to finance their investment
through debt and equity have to rely on their retained earnings and/or bank loans.
Explain how the change in the method of financing corporate investment would
affect the IS curve. (2 marks)

• The change in the method of financing will in general reduce corporate

investment,
• then IS curve will shift leftward and downward.

C04-10(c)
In 2003, SARS seriously affected Hong Kong's economy. To lessen the negative
effect of SARS on our economy, the government partially rebated the salaries tax to
taxpayers. Explain how the tax rebate could lead to an increase in the GDP of Hong
Kong. (4 marks)

Salaries tax rebate → ↑disposable income (1mark) → ↑consumption expenditure

demand (1 mark) → ↑aggregate demand (1 mark) → ↑production of goods and
services (1 mark) →↑actual GDP

C05-11(a)
Two measures included in the Closer Economic Partnership Arrangement or 'Cepa'
are:

I. Zero tariff on 90% of Hong Kong-made products to the Chinese mainland

II. Faster/easier market entry to the Chinese mainland for Hong Kong-based service
providers in 18 service sectors
 HKDSE Notes on Macroeconomics Ch15A Aggregate Demand Page 24 of 26

As a result, overseas companies not based in Hong Kong can take advantage of Cepa
by partnering with a Cepa-qualified manufacturer or service provider in Hong Kong.
Source: Hong Kong SAR Government, 8 January 2005

C05-11(a)
Explain, separately, how the above two measures would affect the gross domestic
product of Hong Kong. (5 marks)

- Zero tariff encourages more export of goods (2m)

- Easier market entry encourages more investment (2m)
- Both measures will increase the GDP of Hong Kong (1m)

C08-11(d)(ii)
Trade deficit is a concern of many countries.
Suppose a country's export value of goods and services decreases by $3 billion. In
reality, the resulting decrease in GDP may be less than or more than $3 billion.
Explain a factor that would lead to a more-than $3 billion decrease in GDP.
(2 marks)

The amount of GDP derived from the spillover effect of the production of the
exports will also decrease.

C09-10(a)
The direct cross-strait flights between mainland China and Taiwan introduced in
2008 facilitate the trading activities between these two places. The GDP of Taiwan
would probably increase with the introduction of the direct cross-strait flights. With
reference to TWO demand-side factors, explain why there is such a possibility.
(4 marks)
 HKDSE Notes on Macroeconomics Ch15A Aggregate Demand Page 25 of 26

• net exports: more net exports (or more export of services) due to more tourists
from mainland China
• consumption: more earnings and income will boost consumption expenditure
• investment: more investment (local and from the Mainland), e.g., more hotels and
trading
• government expenditure: more government expenditure, e.g., more on
infrastructure to facilitate the trade

C10-9(c)
For each of the following situations explain your answer with reference to ONE
demand-side factor. Why would the above expansion increase the gross domestic
product (GDP) of Hong Kong
(i) during the construction period? (2 marks)

• more facilities (attractions) will be constructed => increase in investment

expenditure
• more employment => increase in private consumption expenditure

(ii) after the completion of the construction? (2 marks)

• more tourists from mainland China and other places => increase in net exports
• more local visitors => increase in private consumption expenditure
• more employment => increase in private consumption expenditure

D10-7
Give two reasons why the aggregate demand curve is downward-sloping. (6 marks)

Any two reasons as follows:

• wealth effect: Price level decreases => wealth increases (in real terms) =>
consumption expenditure increases => income increases
 HKDSE Notes on Macroeconomics Ch15A Aggregate Demand Page 26 of 26

• interest rate effect: Price level decreases => real interest rate decreases =>
investment expenditure increases => income increases
• exchange rate effect: Price level decreases => exports becomes relatively cheaper
and imports becomes relatively more expensive => net exports increases =>
income increases

D13-4(a)
Give ONE reason to explain why the aggregate demand curve is downward sloping.
(3 marks)

• Wealth effect: As many of the assets in the economy are denominated in nominal
values, the higher the price level, the lower the purchasing power of money. This
reduces the wealth of the economy (in real terms). As a result, households and
firms reduce their purchases of all goods and services and the real output drops.
• Interest rate effect: As the price level rises, households and firms demand more
money to finance their transactions. Given the fixed supply of money, the
interest rate would rise. An increase in interest rate would cause decline in
investment and consumption and also the real output.
• Net exports effect: As the domestic price level rises, foreign-made goods
become relatively cheaper so the quantity demanded of imports increases.
However, the rise in the domestic price level also means that domestic-made
goods are relatively more expensive to foreign buyers so the quantity demanded
of exports decreases. When the volumes of exports decrease and of imports
increase, net exports will decrease (if the price-elasticities of demand for exports
and/or imports are sufficiently high). Because net exports are a component of
real GDP, the demand for real GDP declines as net exports decline.