2.2 Aggregate Demand

Aggregate demand

The total planned spending on all goods and services produced within an economy over a given period of time

Spending by consumers + spending by firms + spending by the government + net international spending = total spending

C + I + G + (X-M) = AD

Movement in the aggregate demand curve

A movement in the aggregate demand curve occurs when there is a change in the price level of an economy

A decrease in the price level = an extension in aggregate demand

An increase in the price level = a contraction in aggregate demand

Shift in the aggregate demand curve

A shift in the aggregate demand curve is caused by non-price level factors

Aggregate demand/supply theory

As a non-price level factor increases (e.g. exports), aggregate demand shifts right, causing aggregate supply to increase (extension), equalling an increase in the price level and real GDP of an economy

Circular flow of income theory

As a non-price level factor increases (e.g. exports), the value of injections increases, causing the amount of income/money circulating to also increase, equalling an increase in GDP/national income

Aggregate demand/supply theory vs circular flow of income theory

AD/AS theory tells you whether the price level has increased/decreased (inflation/deflation), whereas the circular flow of income theory cannot

Factors that shift aggregate demand - consumption

Income = consumption + savings + taxes; therefore, income, savings (which are affected by interest rates) and taxes all affect consumption

Disposable income = income - taxes; thus, disposable income = consumption + savings, therefore, disposable income (consumer confidence) affects consumption

As wealth and income have a circular relationship, asset prices also affect consumption

Factors that affect consumption - income

If income increases, assuming ceteris paribus, consumption would increase, and vice versa

Factors that affect consumption - savings

If savings decrease, assuming ceteris paribus, consumption would increase, and vice versa

Factors that affect consumption - interest rates

Interest rates are the reward on savings and the cost of borrowing

If interest rates decrease, saving becomes less attractive, and borrowing becomes more attractive, which means that saving rates decrease and borrowing rates increase, causing consumption to increase as consumers are more likely to spend with lower payback on their loan

(e.g. on mortgages and cars, 70% of households are homeowners)

Factors that affect consumption - taxes

If taxes decrease, assuming ceteris paribus, consumption would increase, and vice versa

Factors that affect consumption - consumer confidence

Consumer confidence describes household expectations about the future state of the economy/their income, if they expect the economy to do well in the future, they are more likely to spend in the present; if they expect the economy to do poorly in the future, they are less likely to spend in the present

Factors that affect consumption - wealth effects

If asset prices rise, households may move into positive equity (value of assets>value of debts), allowing them to increase consumption, as they know if they overspend, they can sell assets, clear debts and still have money left over

On the contrary, if asset prices fall, households may move into negative equity (value of assets<value of debts), forcing them to save instead of spend (decreasing consumption) in order to pay off their outstanding debts

Relationships between the factors of consumption and aggregate demand

Income ↑ = consumption ↑ = aggregate demand ↑

Savings ↓ = consumption ↑ = aggregate demand ↑

Interest rates ↓ = consumption ↑ = aggregate demand ↑

Taxes ↓ = consumption ↑ = aggregate demand ↑

Consumer confidence ↑ = consumption ↑ = aggregate demand ↑

Asset prices ↑ = consumption ↑ = aggregate demand ↑

Investment

Net investment = gross investment - depreciation

Overall change in the economies capital stock = investment in new capital - loss of value in existing capital

Evaluation of investments

Investment into an economy will not increase the capital stock and productive capacity/economic growth if the depreciation of capital is greater than the investment, therefore the effect of the investment always depends on the level of the capital depreciation

Factors that shift aggregate demand - investment

Business confidence

Corporation/business taxes

Animal spirits

Growth/profits

Exports/profits

Regulations

Interest rates

Access to credits

Factors that affect investment - business confidence

Business confidence describes business expectations about the future state of the economy/their profits, if they expect the economy to do well in the future, they are more likely to invest in the present; if they expect the economy to do poorly in the future, they are less likely to invest in the present

Factors that affect investment - corporation/business taxes

Taxes on firms decrease retained profits (disposable income for firms), decreasing the amount of investment into new capital, lower taxes on firms can increase retained profits, increasing the amount of investment into new capital

Factors that affect investment - animal spirits

The theory by John Maynard Keynes that business investment can be driven by emotional and social factors rather than rational profit maximising, this can be due to herd behaviour, whereby investors simply follow other investors’ behaviour, or it can also be due to instinctive behaviour, where investors use their emotional ‘gut instinct’ to decide whether to invest

Factors that affect investment - growth/profits

In periods of high economic growth, consumer income and spending are likely to rise, increasing profits for firms, allowing for more investment, and vice versa

Factors that affect investment - exports/profits

In periods of high export demand, international consumers are likely to increase spending, increasing profit for firms, allowing for more investments, and vice versa

Factors that affect investment - regulations

Some regulations apply across the economy (e.g. health and safety, workers’ rights, equality/environmental rights), and they typically increase costs to enter/produce in a market, reducing profits, reducing investments

Factors that affect investment - interest rates

Interest rates are the reward on savings and the cost of borrowing

If interest rates decrease, saving becomes less attractive, and borrowing becomes more attractive, which means that saving rates decrease and borrowing rates increase, causing investment to increase as producers are more likely to invest with lower payback on their loan, allowing them to fund capital investment on a large scale

Thomas Piketty’s theory of capital in the 21st century concludes that the return on capital invested is, on average, 4.5% a year, therefore the historical profit rate is too low and will take 20 to 25 years to double in size, meaning the majority of firms rely on loans to invest and grow

Factors that affect investment - access to credit

In times of recession, especially financial crises (e.g. 2008), access to credit (the ability to get a loan) is very difficult as economies may suffer from a lack of liquidity (availability of cash)/a ‘credit crunch’, in which a lack of cash/banking confidence reduces access to funding for investments

Relationships between the factors of investment and aggregate demand

Business confidence ↑ = investment ↑ = aggregate demand ↑

Corporation/business taxes ↓ = investment ↑ = aggregate demand ↑

Animal spirits ↑ = investment ↑ = aggregate demand ↑

Growth/profits ↑ = investment ↑ = aggregate demand ↑

Exports/profits ↑ = investment ↑ = aggregate demand ↑

Regulations ↓ = investment ↑ = aggregate demand ↑

Interest rates ↓ = investment ↑ = aggregate demand ↑

Access to credits ↑ = investment ↑ = aggregate demand ↑

Factors that shift aggregate demand - government spending

The trade cycle

Fiscal policy

Factors that affect government spending - the trade cycle

In a recession/depression, unemployment is higher, so government spending on unemployment benefits (e.g. universal credit) automatically increases; however, in a boom (period of rising GDP), unemployment typically falls, so government spending decreases as less people are unemployed, meaning fewer people need benefits

Factors that affect government spending - fiscal policy

By definition, any deliberate change in government spending (fiscal policy) will increase/decrease government spending (e.g. more/less spending on the NHS, military and schools)

If they choose to increase government spending, it is known as expansionary fiscal policy

If they choose to decrease government spending, it is known as contractionary fiscal policy

Relationships between the factors of government spending and aggregate demand

Recession = government spending ↑ = aggregate demand ↑

Boom = government spending ↓ = aggregate demand ↓

Expansionary fiscal policy = government spending ↑ = aggregate demand ↑

Contractionary fiscal policy = government spending ↓ = aggregate demand ↓

Factors that shift aggregate demand - exports and imports

Domestic income/GDP

Foreign income/GDP of exports

Protectionism

Relative price levels/inflation

Exchange rates

Factors that affect exports and imports - domestic income/GDP

If an economy gets more national income/GDP, assuming ceteris paribus, imports should rise as domestic consumers can afford to import more

Factors that affect exports and imports - foreign income/GDP

If another country gets more national income/GDP, assuming ceteris paribus, exports should rise as foreign consumers can afford to buy more from domestic firms

Factors that affect exports and imports - protectionism

The use of government policies to reduce imports, such as domestic protectionism against foreign countries, reduces imports (USA tariffs on China reduce USA’s imports)

Foreign protectionism against a domestic country reduces domestic exports (USA tariffs on China reduce China’s exports)

Factors that affect exports and imports - relative price levels/inflation

If a country experiences rapid inflation/price increases, its exports would become less attractive to foreign consumers, and its domestic consumers would be less likely to buy domestic products as they can import goods for cheaper, therefore, having relatively high prices would decrease exports and encourage imports, lower relative prices would increase exports and decrease imports

Factors that affect exports and imports - exchange rates

The price of one currency in terms of another currency; appreciation is when a currency gets more valuable (stronger), and depreciation is when a currency gets less valuable (weaker)

Relationships between the factors of exports/imports and aggregate demand

Domestic income/GDP ↑ = imports ↑ = aggregate demand ↑

Foreign income/GDP ↑ = exports ↑ = aggregate demand ↑

Protectionism