(2.2) Aggregate Demand

• Aggregate demand (AD)


  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


  Consumer spending on goods and services, makes up about 60% of AD
• Investment


  Spending by businesses on capital goods, such as new equipment and buildings as well as working capital, makes up about 15-20% of AD
• Government spending


  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, tends to be around 18-20% of GDP
• Net exports


  Exports minus imports, the UK has a large trade deficit, but this is the least significant part of AD at around 5%
• AD curve


  • Downward sloping as a rise in prices causes a fall in real GDP
  • Reasons: income effect, substitution effect, real balance effect, interest rate effect
• Movement along AD curve


  Caused by a change in prices, due to inflation or deflation
• Shift of AD curve


  Caused by a change in any other variable, a shift to the right represents an increase in AD and a shift to the left represents a fall in AD
• Disposable income (Y)


  The money consumers have left to spend, after taxes have been taken away and any state benefits have been added
• Marginal propensity to consume (MPC)


  How much an increase in income affects consumption, for most people it will be positive but less than 1
• Average propensity to consume (APC)


  The average amount spent on consumption out of total income, in an industrialised country it is likely to be less than one
• Marginal propensity to save (MPS)


  How much of an increase in income is saved
• Average propensity to save (APS)


  The average amount saved out of income
• Interest rates


  Affect the cost of goods bought on credit, high interest rates lead to a reduction in consumption
• Consumer confidence


  Affects people's spending based on their expectations about the future, e.g. expectations about inflation, recession, taxation, interest rates
• Wealth effects


  A change in consumption following a change in wealth, e.g. from rising house or share prices
• Gross investment


  The amount of investment carried out, ignoring depreciation
• Net investment


  Gross investment minus the value of depreciation
• Influences on investment


  • Rate of economic growth
  • Interest rates
  • Business confidence
  • Taxation
• A firm increases advertising


  Demand curve shifts right
• Demand curve shifting right


  Increases the equilibrium price and quantity
• Marginal utility


  The additional utility (satisfaction) gained from the consumption of an additional product
• If you add up marginal utility for each unit you get total utility
• Business expectations and confidence- 'Animal spirits'


  When businesses are confident about the future and expect future growth, investment will increase as they want to prepare for the future. If they are fearful of the future, then they will not invest money in new ideas or machinery
• World economy is booming


  Demand for exports is likely to increase and therefore exporting firms' investment is likely to increase to cope with this extra demand
• Interest rates


  High interest rates mean that borrowing is more expensive, so a business needs to be more confident of good profits in order to cover the extra costs of borrowing. A rise in interest rates increases the opportunity cost of a business using retained profits as they are able to get higher interest payments than before
• Higher interest rates


  Lead to a fall in investment (Keynes' Marginal Efficiency of Capital (MEC) graph)
• Influence of government and regulations


  Governments can encourage investment by their own policy decisions e.g. offering tax breaks or grants. Regulations also affect investment as a highly regulated economy tends to see less investment as regulation increases the cost and time taken to invest
• Access to credit


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


  Profits kept by a firm and not shared with shareholders or used to pay taxes. If firms are making higher retained profits, investment is likely to increase as they have money available to invest
• Technological change


  Improvements in technology will improve or speed up production which will increase the level of profitability, meaning the investment has a better prospect of success. Change also means 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 will decrease investment as it will reduce profitability
• Government spending


  The government has a very significant part to play in the level of AD, through spending on defence, education, the NHS etc.
• Changes in government spending and tax


  If they rise by the same amount then there is likely to be no overall increase in demand as people have less disposable income so C decreases but G increases
• Influences on government expenditure


  The trade cycle, fiscal policy, age distribution of the population
• Net trade


  The total exports minus the total imports
• High real income in the UK


  Tends to be increased imports as people demand more goods and services and the UK is unable to meet their needs, so net trade decreases
• Strong pound


  Makes imports cheap and exports dear, so imports will increase and exports will decrease so net trade will decrease. This depends on the elasticity of imports and exports
• UK's main export country doing well


  UK exports are likely to rise and so net trade is likely to rise