Aggregate Demand

2.2 Aggregate Demand

2.2.1 Characteristics of Aggregate Demand

• Definition: The total level of planned expenditure on all finished goods and services produced in an economy at a specific price level during a given period.

• The AD Equation: $AD = C + I + G + (X - M)$

  • Consumption (C): Total spending by households on goods and services. Typically accounts for approximately 60% of AD, making it the primary driver of economic activity.

  • Investment (I): Spending by firms on capital goods (factories, machinery) and changes in inventories. Represents about 15-20% of AD.

  • Government Spending (G): Expenditure on public services and infrastructure. Excludes transfer payments (pensions, benefits) because these are redistributions of income, not payments for output.

  • Net Exports (X - M): The value of exports sold minus the value of imports purchased. Usually the smallest component but highly volatile.

• The AD Curve and Why it Slopes Downward:

  • The Wealth Effect: As the price level falls, the real value of money and assets (like bank balances) increases, raising the purchasing power of consumers and boosting consumption.

  • The Interest Rate Effect: Lower price levels reduce the demand for money. This downward pressure on interest rates makes borrowing cheaper, encouraging investment (I) and consumption of durables (C).

  • The International Trade Effect: When domestic price levels fall relative to foreign prices, domestic goods become more competitive. Exports rise and imports fall, improving $(X-M)$.

• Movements vs. Shifts: A change in the price level causes a movement along the AD curve. A change in any of the components ($C, I, G, X, M$) independent of the price level causes a shift of the entire curve.

2.2.2 Consumption

• Disposable Income (Yd): This is gross income minus direct taxes plus state benefits. It is the most significant determinant of consumption.

• The Consumption Function: $C = a + b(Yd)$, where $a$ is autonomous consumption (spending when income is zero) and $b$ is the Marginal Propensity to Consume (MPC).

• MPC and APC:

  • Marginal Propensity to Consume (MPC): The proportion of an increase in income that is spent on consumption ($\Delta C / \Delta Y$).

  • Average Propensity to Consume (APC): Total consumption divided by total income ($C / Y$).

• Influencing Factors:

  • Interest Rates: Low rates reduce the cost of credit and reduce the incentive to save. They also lower mortgage repayments, increasing discretionary income.

  • Consumer Confidence: Expectations about future job security and income growth. High confidence leads to 'big ticket' purchases.

  • Wealth Effects: Changes in the value of assets, particularly house prices and stock market portfolios. A 'positive wealth effect' occurs when rising asset prices encourage more spending.

  • Household Indebtedness: High levels of debt can force households to cut spending to pay off loans.

2.2.3 Investment

• Gross vs. Net Investment:

  • Gross Investment: The total amount spent on new capital.

  • Net Investment: Gross investment minus depreciation (capital consumption). Net investment indicates whether the capital stock of an economy is actually growing.

• The Accelerator Effect: The theory that a change in the rate of growth of national income leads to a larger proportionate change in investment levels.

• Influences on Investment:

  • Animal Spirits (Keynes): Business confidence based on human emotion and intuition rather than cold logic. If firms feel 'bullish,' investment rises.

  • Interest Rates and the MEC: Firms compare the expected rate of return on capital (Marginal Efficiency of Capital) with the cost of borrowing (interest rate).

  • Corporation Tax: Lower taxes increase retained profits, providing more internal funds for investment.

  • Technological Progress: Rapid innovation forces firms to invest in new capital to remain competitive.

2.2.4 Government Spending

• Types of Spending:

  • Current Spending: Day-to-day expenditure on wages (teachers, nurses) and consumables.

  • Capital Spending: Long-term investment in assets like roads, hospitals, and schools.

• Influences:

  • The Trade Cycle: During a recession, governments may use expansionary fiscal policy (increasing G) to boost AD. Automatic stabilizers (unemployment benefits) also increase G.

  • Fiscal Rules: Constraints on government borrowing and debt levels can limit the ability to increase spending.

  • Political Priorities: Ideological shifts toward privatization or public service expansion drastically change G levels.

2.2.5 Net Trade

• Influencing Factors:

  • Relative Real Income: If domestic income grows faster than income in trading partners, imports will generally rise faster than exports, worsening the trade balance.

  • Exchange Rates (SPICED): Strong Pound, Imports Cheap, Exports Dear. A stronger currency usually leads to a decrease in net exports.

  • Degree of Protectionism: The use of tariffs, quotas, and subsidies by trading partners impacts export volumes.

  • Non-Price Competitiveness: Factors like product quality, reliability, after-sales service, and branding contribute to trade success regardless of price.