Download Aggregate Demand - Business-TES

Aggregate Demand
This section gives you a platform for understanding issues such as inflation, economic growth and
unemployment. Aggregate demand (AD) and aggregate supply (AS) analysis provides a way of illustrating
macroeconomic relationships and the effects of government policy changes. Luckily the AD curve is fairly
uncontroversial. Aggregate supply on the other hand…
Aggregate Demand
Aggregate demand (AD) is the total spending on goods and services made in an economy.
The identity for calculating aggregate demand (AD) is as follows:
AD = C + I + G + (X-M)
Where
C: Consumers' expenditure on goods and services: This includes demand for consumer durables (e.g.
washing machines, audio-visual equipment and motor vehicles & non-durable goods such as food and drinks
which are “consumed” and must be re-purchased). Household spending accounts for over sixty five per cent
of aggregate demand in the UK.
I: Capital Investment – This is investment spending by companies on capital goods such as new plant
and equipment and buildings. Investment also includes spending on working capital such as stocks of
finished goods and work in progress.
Capital investment spending in the UK typically accounts for between 15-20% of GDP in any given year. Of
this investment, 75% comes from private sector businesses such as Tesco, British Airways and British
Petroleum and the remainder is spent by the public (government) sector – for example investment by the
government in building new schools or investment in improving the railway or road networks. So a mobile
phone company such as O2 spending £100 million on extending its network capacity and the government
allocating £15 million of funds to build a new hospital are both counted as part of capital investment.
Investment has important long-term effects on the s supply-side of the economy as well as being an
important although volatile component of aggregate demand.
G: Government Spending – This is government spending on state-provided goods and services including
public and merit goods. Decisions on how much the government will spend each year are affected by
developments in the economy and also the changing political priorities of the government. In a normal year,
government purchases of goods and services accounts for around twenty per cent of aggregate demand.
We will return to this again when we look at how the government runs its fiscal policy.
Transfer payments in the form of welfare benefits (e.g. state pensions and the job-seekers allowance) are
not included in general government spending because they are not a payment to a factor of production for
any output produced. They are simply a transfer from one group within the economy (i.e. people in work
paying income taxes) to another group (i.e. pensioners drawing their state pension having retired from the
labour force, or families on low incomes).
The next two components of aggregate demand relate to international trade in goods and services
between the UK economy and the rest of the world.
X: Exports of goods and services - Exports sold overseas are an inflow of demand (an injection) into
our circular flow of income and therefore add to the demand for UK produced output.
M: Imports of goods and services. Imports are a withdrawal of demand (a leakage) from the circular
flow of income and spending. Goods and services come into the economy for us to consume and enjoy - but
there is a flow of money out of the economy to pay for them.
Net exports (X-M) reflect the net effect of international trade on the level of aggregate demand. When
net exports are positive, there is a trade surplus (adding to AD); when net exports are negative, there is a
trade deficit (reducing AD). The UK economy has been running a large trade deficit for several years now
as has the United States.
IB Economics notes
Aggregate Demand
[email protected]
Aggregate demand shocks
Economic events such as changes in interest rates and economic growth in the United States can have a
powerful effect on other countries including the UK. This is because the USA is the world’s largest economy.
15 per cent of our exports go to the USA.
Lots of unexpected events can happen which cause changes in the level of demand, output and
employment in the economy. These unplanned events are called “shocks” One of the causes of fluctuations
in the level of economic activity is the presence of demand-side shocks.
Some of the main causes of demand-side shocks are as follows:
 A capital investment boom e.g. a construction boom to increase the supply of new houses or to
build new commercial and industrial buildings.
 A rise or fall in the exchange rate – affecting net export demand and having follow-on effects
on output, employment, incomes and profits of businesses linked to export industries.
 A consumer boom abroad in the country of one of our major trading partners which
affects the demand for our exports of goods and services.
 A large boom in the housing market or a slump in share prices.
 An unexpected cut or an unexpected rise in interest rates.
IB Economics notes
Aggregate Demand
[email protected]
The Aggregate Demand Curve
The AD curve shows the relationship between the general price level and real GDP.
Why does the AD curve slope downwards?
There are several explanations for an inverse relationship between aggregate demand and the price level in
an economy. These are summarised below:
 Falling real incomes: As the price level rises, so the real value of people’s incomes fall and
consumers are then less able to afford UK produced goods and services.
 The balance of trade: As the price level rises, foreign-produced goods and services become more
attractive (cheaper) in price terms, causing a fall in exports and a rise in imports. This will lead to a
reduction in trade (X-M) and a contraction in aggregate demand.
 Interest rate effect: if in the UK the price level rises, this causes an increase in the demand for
money and a consequential rise in interest rates with a deflationary effect on the entire economy.
This assumes that the central bank (in our case the Bank of England) is setting interest rates in
order to meet a specified inflation target.
Shifts in the AD curve
A change in factors affecting any one or more components of aggregate demand, households (C), firms (I),
the government (G) or overseas consumers and business (X) changes planned aggregate demand and
results in a shift in the AD curve.
Consider the diagram below which shows an inward shift of AD from AD1 to AD3 and an outward shift of AD
from AD1 to AD2. The increase in AD might have been caused for example by a fall in interest rates or an
increase in consumers’ wealth because of rising house prices.
IB Economics notes
Aggregate Demand
[email protected]
Factors causing a shift in AD
Changes in Expectations
Current spending is affected by
anticipated future income, profit, and
inflation
The expectations of consumers and businesses can have a powerful effect on
planned spending in the economy E.g. expected increases in consumer incomes,
wealth or company profits encourage households and firms to spend more –
boosting AD. Similarly, higher expected inflation encourages spending now before
price increases come into effect - a short term boost to AD.
When confidence turns lower, we expect to see an increase in saving and some
companies deciding to postpone capital investment projects because of worries
over a lack of demand and a fall in the expected rate of profit on investments.
Changes in Monetary Policy – i.e. a An expansionary monetary policy will cause an outward shift of the AD curve. If
change in interest rates
interest rates fall – this lowers the cost of borrowing and the incentive to save,
(Note there is more than one interest thereby encouraging consumption. Lower interest rates encourage firms to borrow
rate in the economy, although
and invest.
borrowing and savings rates tend to
There are time lags between changes in interest rates and the changes on the
move in the same direction)
components of aggregate demand.
Changes in Fiscal Policy
For example, the Government may increase its expenditure e.g. financed by a
Fiscal Policy refers to changes in
higher budget deficit, - this directly increases AD
government spending, welfare benefits
and taxation, and the amount that the Income tax affects disposable income e.g. lower rates of income tax raise
government borrows
disposable income and should boost consumption.
An increase in transfer payments raises AD – particularly if welfare recipients spend
a high % of the benefits they receive.
Economic events in the
international economy
A fall in the value of the pound (£) (a depreciation) makes imports dearer and
exports cheaper thereby discouraging imports and encouraging exports – the net
International factors such as the
result should be that UK AD rises – the impact depends on the price elasticity of
exchange rate and foreign income (e.g. demand for imports and exports and also the elasticity of supply of UK exporters in
the economic cycle in other countries) response to an exchange rate depreciation.
An increase in overseas incomes raises demand for exports and therefore UK AD
rises. In contrast a recession in a major export market will lead to a fall in UK
exports and an inward shift of aggregate demand.
The UK is an open economy, meaning that a large and rising share of our national
output is linked to exports of goods and services or is open to competition from
imports.
Changes in household wealth
A rise in house prices or the value of shares increases consumers’ wealth and allow
Wealth refers to the value of assets
an increase in borrowing to finance consumption increasing AD. In contrast, a fall
owned by consumers e.g. houses and in the value of share prices will lead to a decline in household financial wealth and
shares
a fall in consumer demand.
IB Economics notes
Aggregate Demand
[email protected]