Aggregate demand

• AD= C+I+G+(X-M)
• Consumption ​is consumer spending on goods and services; it makes up about 60% of AD, so is the biggest part.
• • Investment is spending by businesses on capital goods, such as new equipment and buildings as well as working capital e.g. stocks and work in progress; it makes up about 15-20% of AD. Most investment is by the private sector (about 75%) but there is also investment by the government.
• Government spending is spending by the government on providing goods and services, generally public and merit goods, both on wages and salaries of public sector workers and on investment goods like new roads and schools.

  • This will change year on year as governments decides how much they spend. Transfer payments such as pensions and jobseekers’ allowances aren’t included in the figure as money is just transferred from one group to another. Government spending tends to be around 18-20% of GDP.
• Net exports is exports minus imports: when imports are higher than exports this is a 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%.
• the AD curve is ​downward sloping as a rise in prices causes a fall in real GDP and there are four key 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 want to buy British exports and more UK residents will want to buy imported foreign goods because they are cheaper. The rise in imports and fall of exports will decrease net exports so AD will contract.
• • Real balance effect​: A rise in prices will mean that the amount people have saved up will no longer be worth as much and so will offer less security. As a result, 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.
• Disposable income (Y) is the ​money consumers have left to spend​, after taxes have been taken away and any state benefits have been added. This means that disposable income is affected by government taxation as well as wages.
• MPC= ​change in consumption / change in income
• MPS= ​change in savings / change in income
• APS= ​total savings / total income
• Other influences on consumer spending:

  • interest rates
  • consumer spending
  • wealth effect
  • distribution of income
• Investment is the ​addition of capital stock to the economy i.e. machines and factories used to produce other goods and services. It is only seen as investment if real products are created so buying a share in a company would be saving but buying new machinery is investment.
• Machinery depreciates (loses its value) over time as it wears out or gets used up. ​Gross investment is the amount of investment carried out and ignores the level of depreciation, whilst ​net investment​ is gross investment minus the value of depreciation.
• Influences on investment:

  • rate of economic growth
  • business expectations and animal spirits
  • demand for exports
  • interest rates
  • influence of government and regulations
  • access to credit
  • retained profit
  • technological change
  • costs
• 1. The government has a very significant part to play in the level of AD, through spending. They spend money on defence, education, the NHS etc.
• Influences on government expenditure:

  • the trade cycle - decisions over government expenditure may be made in order to manage AD, and therefore regulate the trade cycle. In a recession, the government may increase spending in order to increase demand to reduce unemployment.
  • fiscal policy
  • age distribution - ​An ageing population leads to increased government expenditure on pensions, social care etc. 
• Exporting goods abroad brings money into the country as there is an increase in AD whilst importing goods means money leaves the country. Net trade is the ​total exports minus the total imports.
• Influences on net trade balance:

  • real income
  • exchange rates
  • state of world economy
  • degree of protectionism
  • Prices