2.2.1 Characteristics of aggregate demand

AGGREGATE DEMAND- DEFINITION

• the total level of spending in the economy at any given price

COMPONENTS OF AD

• AD= C+l+G+(X-M)

• made up of consumption (C), investment (I), government spending (G) and net exports (X-M)

CONSUMPTION

• consumer spending on g and s

• makes up about 60% of AD

INVESTMENT

• spending by firms on capital goods (e.g. new equipment)

• makes up about 15-20% of AD

• most investment is by the private sector (about 75%) but there is also investment by the gov

GOVERNMENT SPENDING

• spending by the gov on providing g and s (public and merit goods), wages and salaries of public sector workers and on investment goods like new roads and schools

• transfer payments (e.g. pensions and jobseekers' allowances) not included as money is just transferred from one group to another

• gov spending is around 18-20% of GDP

NET EXPORTS

• exports minus imports

• when imports>exports=minus figure as more money leaves the UK than comes in

• the UK has a large trade deficit, but this minor figure and is the least significant part of AD at around 5%

AD CURVE

• same as demand curve for an individual market

• instead shows the relationship between general price level and real GDP

• AD curve is downward sloping as a rise in prices causes a fall in real GDP (inverse relationship)

• 4 reasons for this:

• income effect

• substitution effect

• real balance effect

• interest rate effect

INCOME EFFECT

• as a rise in prices is not matched straight away by a rise in income, people have lower real incomes so can afford to buy less, leading to a contraction demand

SUBSTITUTION EFFECT

• if prices in the UK rise, less foreigners will buy British exports and more UK residents will buy imported foreign goods bc they’re cheaper

• rise in imports and fall of exports will decrease net exports so AD will contract

REAL BALANCE EFFECT

• rise in prices means the amount people have saved up will no longer be worth as much and so will offer less security

• they will want to save more and so reduce their spending, causing a contraction in AD

INTEREST RATE EFFECT

• rising prices mean firms have to pay their workers more and so there is higher demand for money

• if supply stays the same, then the 'price of money' i.e. interest rates will rise because of this higher demand

• higher interest rates mean that more people will save and less will borrow and will also mean that businesses invest less, so AD will contract

MOVEMENT ALONG AD CURVE

• movement along the AD curve is caused by a change in prices, caused by inflation or deflation

SHIFT OF AD CURVE

• shift of the AD curve is caused by a change in any other variable

• right shift represents increase in AD and left shift represents decrease in AD

• absolute change: fall in the amount of consumption reduces AD

• rates of change: fall in the rate of rise of consumption means that consumption is still rising so AD will still increase but by not as much