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Aggregate demand is the sum of the combined demand for goods and services in an economy within a period under consideration. Several factors can lead to increases in aggregate demand such as monetary policies, fiscal policies, wage increases and the expectations of the citizens. All of these factors are macroeconomic factors that may increase the aggregate demand.
Monetary policies cause increases in aggregate demand because the central bank of a country uses this particular economic factor as a tool to manipulate the spending of the citizens in a country. When the central bank perceives a sustained general drop in the level of demand, it may decide to lower interest rates in order to encourage more people to spend money. A reduction of interest rates causes the banks in the country to decrease the interest on savings, thus reducing the incentives for people to save money. Reduced interest rates also mean that loans and credit are more readily available to consumers, giving them the means with which to purchase goods and services.
Government fiscal policies may lead to increases in aggregate demand in certain circumstances. For example, a decrease in income tax leads to an increase in the money that consumers have to spend, and in turn, aggregate demand. Periods of economic boom also lead to aggregate demand increases because such periods are usually fueled by an increase in consumer confidence, which results in more demand for products and services.
Expectations of inflation on the part of the consumers may lead to an increase in aggregate demand by the effect it has on consumers. When people feel that there will be a scarcity of certain commodities or that the price of certain commodities will soon go up, it may lead to panic buying as people buy goods in large quantities and hoard them. Such an action leads to increases in aggregate demand of goods and services.
The right mix of fiscal policies, monetary policies and a stable economy may lead to increased demand for local products and raw materials from other countries. Such outside demand will lead to an increase in domestic exports and is also affected by other factors like favorable tax regimes and reduced custom duties. This type of demand is also a contributing factor to an increase in the total aggregate demand in an economy.
It is a very, very frightening thing when a central government can manipulate markets through economic policies. That is not a situation that goes over well in a capitalist economy.
Take a look, for example, at the United States government's notion to increase the number of people buying homes a few years ago by offering tax credits -- cash, essentially -- to people purchasing homes. There was a lot of buying activity for a couple of years as a direct response to the program, but at least two undesirable side effects also arose.
First, home values were artificially inflated due to the influx of buyers, leaving people in the position of find their homes were worth significantly less after the
program expired. Also, the policy dragged the housing slump on for longer because markets took a nosedive right after the program ended.
Artificially inflated home prices and a longer housing slump were not desirable and would have been avoided had the federal government refrained from fooling around with the housing market.