2.2 Aggregate Demand

• Aggregate demand (AD) is the total level of spending in the economy at any given price
• Components of AD:

  • Consumption (C)
  • Investment (I)
  • Government spending (G)
  • Net exports (X-M)
• Consumption makes up about 60% of AD, the biggest part
• Investment makes up about 15-20% of AD, with most investment by the private sector
• Government spending is around 18-20% of GDP, including spending on public goods and services
• Net exports is exports minus imports, around 5% of AD in the UK
• The AD curve shows the relationship between price level and real GDP, and is downward sloping
• Reasons for the downward slope of the AD curve:

  • Income effect
  • Substitution effect
  • Real balance effect
  • Interest rate effect
• Movements along the AD curve are caused by changes in prices, while shifts are caused by changes in other variables
• A fall in consumption reduces AD, but a fall in the rate of rise of consumption means AD still increases but by not as much
• Consumption is spending on consumer goods and services over a period of time
• Disposable income (Y) is what consumers have left to spend after taxes and state benefits
• Marginal propensity to consume (MPC) is how much spending increases with income, usually positive but less than 1
• Poorer people tend to have a higher MPC, while richer people are more likely to save
• Average propensity to consume (APC) is the average amount spent on consumption out of total income
• Savings is what is not spent out of income, influenced by factors affecting consumption in the opposite way
• Influences on consumer spending:

  • Interest rates
  • Consumer confidence
  • Wealth effects
  • Distribution of income
  • Tastes and attitudes
• Investment is the addition of capital stock to the economy, such as machines and factories
• Gross investment ignores depreciation, while net investment is gross investment minus depreciation
• Rate of economic growth influences investment levels, with higher growth leading to more investment
• Depreciation accounts for about 75% of gross investment in the UK
• Rate of economic growth:

  • In a growing economy, there will be higher levels of investment as businesses would be more confident about their investments and the higher demand would lead to a higher return rate on the investment
  • A growing economy needs more investment to cope with the higher levels of demand
  • If the economy is declining, there would be no or little return on the investment
• Business expectations and confidence- ‘Animal spirits’:

  • When businesses are confident about the future and expect future growth, investment will increase
  • If businesses are fearful of the future, they will not invest money in new ideas or machinery
  • John Maynard Keynes used the term ‘animal spirits’ to describe the feeling of managers and owners of firms on whether their investment would be profitable
• Demand for exports:

  • If the world economy is booming, demand for exports is likely to increase
  • Exporting firms’ investment is likely to increase to cope with the extra demand
  • This will encourage other firms to increase their investment
• Interest rates:

  • High interest rates mean that borrowing is more expensive, so a business needs to be more confident of good profits to cover the extra costs of borrowing
  • A rise in interest rates increases the opportunity cost of a business using retained profits
• Influence of government and regulations:

  • Governments can encourage investment by offering tax breaks or grants to businesses
  • Regulations affect investment as a highly regulated economy tends to see less investment
• Access to credit:

  • Investment will be lower when an investment has a high risk attached to it
  • In recessions, it is usually more difficult to access credit as risks are higher and banks become more risk aware
• Retained profit:

  • Retained profits are the profits kept by a firm and not shared with shareholders or used to pay taxes
  • Firms making higher retained profits are likely to increase investment as they have money available to invest
• Technological change:

  • Improvements in technology will improve or speed up production, increasing profitability
  • Businesses need to invest to keep up with the best technology
• Costs:

  • A rise in the cost of any capital project increases the level of risk and leads to lower levels of investment
  • Rises in the costs of making goods decrease investment as it reduces profitability
• Government spending:

  • The government spends money on defence, education, the NHS, etc.
  • A rise in government spending impacts AD, depending on changes in tax
• Influences on government expenditure:

  • Decisions over government expenditure may be made to manage AD and regulate the trade cycle
  • Fiscal policy is the decisions about government spending and taxes
• Net trade:

  • Exporting goods abroad brings money into the country, while importing goods means money leaves the country
  • Net trade is the total exports minus the total imports
• Influences on net trade balance:

  • Real income in the UK affects net trade
  • Exchange rates impact net trade
  • The state of the world economy influences net trade
  • Degree of protectionism affects net trade
  • Non-price factors like quality, design, and marketing influence net trade
  • Prices of UK goods affect net trade