Economics 2.2. Aggregate Demand

What is Aggregate Demand (AD)?

Aggregate demand (AD) is the total level of spending in an economy at a given price level. It is made up of:

• Consumption (C)

• Investment (I)

• Government spending (G)

• Net exports (X - M)

What are the components of Aggregate Demand (AD)?

Consumption (C): Spending by households on goods and services. It makes up about 60% of AD.

Investment (I): Spending by businesses on capital goods (e.g., machinery, equipment) and working capital. It makes up around 15-20% of AD.

Government spending (G): Government expenditure on public goods and services. It makes up about 18-20% of GDP.

Net Exports (X-M): Exports minus imports. The UK often has a trade deficit, and net exports make up about 5% of AD

What is the AD curve?

The Aggregate Demand (AD) curve shows the relationship between the price level and real GDP.

• It is downward sloping because as the price level increases, real GDP decreases, resulting in a contraction in demand.

• A rise in prices causes a fall in the quantity of goods and services demanded.

What are the four key reasons for the downward slope of the AD curve?

1. Income effect: When prices rise, real incomes fall, so people buy less.

2. Substitution effect: Higher prices reduce demand for exports and increase imports, decreasing net exports.

3. Real balance effect: Higher prices reduce the value of savings, leading people to save more and spend less.

4. Interest rate effect: Higher prices increase demand for money, causing higher interest rates, which reduce borrowing and investment, decreasing AD.

What causes movement along the AD curve?

• Movement along the AD curve is caused by changes in the price level.

• A rise in prices causes a movement up along the curve (decrease in AD), and a fall in prices causes a movement down along the curve (increase in AD).

What causes a shift of the AD curve?

• A shift in the AD curve occurs due to changes in any other variable that affects AD, such as:

  • Changes in government spending

  • Changes in consumer confidence or tax rates

  • Changes in interest rates or investment

• A shift to the right indicates an increase in AD, while a shift to the left indicates a decrease in AD.

What is the difference between movement along and a shift in the AD curve?

• Movement along the AD curve occurs due to changes in the price level (inflation or deflation).

• Shift in the AD curve occurs due to changes in other factors such as interest rates, government policies, or consumer spending.

How do changes in interest rates affect the AD curve?

• Movement along the AD curve: If prices increase, interest rates rise due to the interest rate effect, leading to a movement along the curve.

• Shift of the AD curve: If the government raises interest rates, it will shift the AD curve leftward (decrease in AD).

What is the significance of distinguishing between the rates of change and absolute change?

• A fall in consumption reduces AD.

• A fall in the rate of rise of consumption means consumption is still increasing, but at a slower rate, so AD still increases, just not as much.

What is Consumption?

Consumption refers to the spending on goods and services by households over a period of time. It is a key component of Aggregate Demand (AD).

What is Disposable Income?

Disposable income (Y) is the income left after taxes are deducted and state benefits are added.

• It determines how much people can spend.

• Higher disposable income leads to higher consumption.

What is the Marginal Propensity to Consume (MPC)?

• The MPC is the change in consumption resulting from a change in income.

• Formula:
  MPC=Change in ConsumptionChange in IncomeMPC=Change in IncomeChange in Consumption​

• Typically, MPC is positive but less than 1, meaning an increase in income leads to more spending, but not as much as the income increase.

• Low-income individuals tend to have a higher MPC because they are more likely to spend extra income.

What is the Average Propensity to Consume (APC)?

The APC is the average amount spent on consumption relative to total income.

• Formula:
  APC=Total Consumption/Total Income

• In industrialized countries, APC is usually less than 1 as people save part of their income.

What is the Relationship Between Consumption and Savings?

• Savings is the portion of income not spent on consumption.

• Marginal Propensity to Save (MPS) is the change in savings due to a change in income.

  • Formula:
    MPS=Change in Savings/Change in Income

• Average Propensity to Save (APS) is the average amount saved relative to total income.

  • Formula:
    APS=Total Savings/Total Income

How Do Interest Rates Affect Consumption?

• High interest rates increase the cost of borrowing (e.g., for mortgages or credit cards), making goods and services more expensive, leading to reduced consumption.

• Higher interest rates also reduce wealth (e.g., through lower share prices), leading to a negative wealth effect, which can further reduce spending.

How Does Consumer Confidence Influence Consumption?

• Optimistic consumers (e.g., expecting pay raises or economic stability) tend to increase consumption.

• Pessimistic consumers (e.g., fearing recession or unemployment) decrease consumption.

• Expectations: If consumers expect higher future taxes or prices, they may buy now. If they expect falling interest rates, they might delay purchases.

What Are Wealth Effects?

• The wealth effect occurs when changes in the value of assets (like houses or shares) influence consumption.

  • Rising house prices or higher share prices increase consumers’ perceived wealth, making them feel more financially secure and willing to spend more.

How Does the Distribution of Income Affect Consumption?

Low-income individuals have a higher marginal propensity to consume (MPC) than high-income individuals, so if wealth shifts from the rich to the poor, overall consumption will increase

How Do Tastes and Attitudes Influence Consumption?

• A materialistic society encourages higher spending, especially on the latest goods and services, leading to increased consumption.

• If people were less materialistic, consumption would likely decrease, as spending would be more restrained.

What is Investment?

Investment refers to the addition of capital goods (like machinery, factories, and equipment) to the economy to produce other goods and services.

• Investment occurs when real products are created, such as purchasing new machinery.

• Example: Buying a share in a company is not investment; buying new machinery is.

Gross vs. Net Investment

• Gross Investment: The total amount spent on investment without accounting for depreciation.

• Net Investment: Gross investment minus depreciation (the loss of value of existing capital).

  • Example: If a firm buys 5 new machines and replaces 2 old ones, gross investment is the value of the 5 new machines, but net investment is the value of the 5 new machines minus the 2 old ones.

  • Depreciation can account for up to 75% of gross investment in economies like the UK.

Influences on Investment: Rate of Economic Growth

• In a growing economy, investment increases because businesses are more confident, and there is higher demand, leading to better returns on investment.

• In a shrinking economy, firms don’t need to invest in new capital as there is less demand, leading to lower investment.

Business Expectations and Confidence (Animal Spirits)

• Animal spirits: A term coined by economist John Maynard Keynes to describe the emotions and confidence of business owners and managers in their investment decisions.

• When businesses are confident about future growth, they are more likely to invest.

• Fear or uncertainty leads to lower investment.

Influence of Export Demand on Investment

• Increased demand for exports (due to global economic growth) leads to higher investment from exporting firms to meet the extra demand.

• This increase in investment can encourage other firms to follow suit and invest.

How Do Interest Rates Affect Investment?

• High interest rates make borrowing more expensive, increasing the cost of investment.

• When interest rates rise, the opportunity cost of using retained profits (investing them in other ways for interest returns) increases, leading firms to be more cautious.

• Keynes' Marginal Efficiency of Capital (MEC): If the expected rate of return on investment is lower than the interest rate, firms are less likely to invest.

Influence of Government and Regulations

• Government policies can encourage investment through measures like tax breaks or grants.

• However, excessive regulations (e.g., strict planning laws) can discourage investment by increasing costs and time for approval.

Access to Credit

• Firms find it harder to get credit when investment risks are high or in a recession, leading to lower levels of investment.

• Tighter credit means firms can’t easily borrow funds to invest, thus reducing their ability to expand or replace capital.

Retained Profits and Investment

• Retained profits are the profits that businesses keep rather than paying out as dividends or taxes.

• If firms have higher retained profits, they can fund investment internally without borrowing, which increases investment levels.

• Firms may be reluctant to borrow if they fear the investment will fail, so higher retained profits make it more likely that investment will occur.

Technological Change and Investment

• Technological advancements make production more efficient, improving profitability and encouraging firms to invest to keep up with new technology.

• Firms need to continually invest to stay competitive and take advantage of better technologies.

Cost Factors Affecting Investment

Higher costs (e.g., increased raw material prices or wages) raise the risk of investment and reduce profitability.

Rising production costs mean firms may have less money to invest and may cut back on new investment.

How Economic Confidence Affects Investment

• When firms are optimistic about future economic conditions (e.g., anticipating higher demand or better returns), they are more likely to invest.

• When firms are pessimistic or uncertain, they tend to reduce or postpone investment.

Investment During a Recession

• In a recession, businesses expect low returns and may be hesitant to invest.

• Investment falls during recessions due to reduced demand and confidence.

Impact of Taxation on Investment

• Higher taxes can reduce the after-tax return on investments, which may deter firms from making new investments.

• Conversely, tax incentives (e.g., tax cuts or credits) can encourage investment.

What is the Role of Government Spending in Aggregate Demand (AD)?

• Government spending has a significant impact on AD, as it directly increases demand for goods and services (e.g., spending on defence, education, healthcare).

• If government spending and taxation increase by the same amount, no overall increase in demand will occur because the increase in government spending is offset by a decrease in disposable income (less consumption).

Government Spending & the Trade Cycle

• Trade Cycle: Government spending is used to regulate the trade cycle.

  • During a recession: The government may increase spending to stimulate demand and reduce unemployment.

  • During a boom: The government may decrease spending to reduce inflation and prevent overheating of the economy.

Automatic Government Spending During Recessions

• During recessions, government spending automatically rises due to:

  • Increased unemployment benefits.

  • Increased spending on other welfare programs, as demand for support rises.

What is Fiscal Policy?

• Fiscal Policy: The government's decisions about spending and taxation.

  • The level of government spending is influenced by the priorities of the government, and these are often outlined in their annual budget.

  • Fiscal policy can be used to either stimulate the economy (increase spending) or cool it down (decrease spending) depending on economic conditions.

Impact of the Age Distribution on Government Spending

• Ageing Population: An older population requires more spending on pensions and social care.

• Young Population: A younger population leads to higher spending on education and youth services.

• More dependents (young and old) in an economy typically leads to higher government spending.

What is Net Trade?

• Net Trade is the difference between exports and imports.

  • Exports bring money into the country, increasing Aggregate Demand (AD).

  • Imports cause money to leave the country, decreasing AD.

• Formula:

  Net Trade= Exports - Imports

How Does Real Income Affect Net Trade?

• Real Income: When real income in the UK rises:

  • Imports increase because people demand more goods and services, which the UK cannot produce.

  • This results in a decrease in net trade.

  • However, if income growth is export-led, net trade will increase.

• Impact: The effect of income changes on net trade depends on whether the growth is driven by imports or exports.

How Do Exchange Rates Affect Net Trade?

• Strong Pound: A stronger pound makes imports cheaper and exports more expensive.

  • This leads to an increase in imports and a decrease in exports, thus reducing net trade.

• Elasticity:

  • If imports and exports are price elastic, a stronger pound will cause a larger decrease in exports and a larger increase in imports, lowering net trade.

  • If imports and exports are price inelastic, the effect of a stronger pound on net trade may be smaller.

How Does the State of the World Economy Influence Net Trade?

• If the UK’s main export countries are doing well, UK exports will rise, and net trade will increase.

• The state of the world economy depends on the performance of the UK’s key trading partners and the trade relationship the UK has with them.

How Does Protectionism Affect Net Trade?

• Protectionism refers to policies (tariffs, quotas, etc.) that limit foreign competition and protect domestic industries.

  • If other countries have high protectionism on UK exports, exports decrease.

  • If the UK imposes protectionism, imports will decrease but may lead to retaliation from other countries, potentially decreasing exports.

• Free Trade: Promotes a larger role for net trade in AD, which can be either positive or negative.

How Do Non-Price Factors Affect Net Trade?

• Quality & Design:

  • High quality and design of UK goods lead to higher demand for exports, increasing net trade.

  • If UK goods are perceived as better than foreign goods, people will prefer to buy UK products, reducing imports.

• Marketing: Effective marketing can boost the desirability of UK goods, further increasing exports and reducing imports, leading to higher net trade.

How Do Prices Affect Net Trade?

• High Prices: If UK goods are priced higher than foreign goods, they become less competitive.

  • Exports decrease and imports increase, causing net trade to fall.

• Inflation & Productivity:

  • Higher inflation in the UK relative to other countries leads to higher prices, which decreases export competitiveness.

  • Higher productivity leads to lower costs, making UK goods more competitive and helping increase exports.