2.2 Aggregate demand notes for Edexcel A Economics

Aggregate demand definition

Aggregate demand (AD) is the total demand for all goods and services in the economy (at a given time and price level).

We can break down AD into its various components:

• AD = C + I + G + X – M.
• Where C = consumption, I = investment, G = government spending, X-M is net exports (where X = exports, M = imports). 

Movements along the AD curve

As price level rises, AD falls. This occurs for three reasons:

• 1) A higher price level leads to lower real disposable incomes. This applies to those who incomes rise more slowly than the rate of inflation. This reduces consumption, so AD also falls.
• 2) A higher price level (relative to other countries)  reduces export competitiveness. This lowers export demand, so net exports fall, so AD falls.
• 3) Higher price level leads to the central bank raising interest rates (to control inflation).
  • Higher interest rates increase the cost of borrowing and the reward for saving, which lowers consumption.
  • By increasing the cost of borrowing, investment also falls.

As a result, AD is downward sloping.

Note that changes in other factors, excluding the price level, lead to a shift in the AD curve.

Factors that shift AD

Consumption

Consumption (C) = total value of goods/services bought by households.

Other than price level, the factors that affect consumption include:

• Disposable income – income remaining after paying taxes.
  • Higher disposable income boosts consumption.
    • This effect gets weaker as income grows. In other words, as disposable income rises, consumption increases at a slower rate.
    • This is because at low income levels, extra income is all spent on necessities. However once all necessities are consumed, extra income can be spent on luxuries or saved.
• Interest rates – the reward for saving and cost of borrowing.
  • Higher interest rates lead to a higher reward for saving. This increases incentives to save, so consumers save more and consume less, lowering consumption.
  • Higher interest rates lead to a higher cost of borrowing. This reduces the incentive to borrow, so consumers borrow less, which decreases consumption.
• Consumer confidence rising might lead to higher consumption.
  • For instance, if consumers expect their future incomes to be higher, consumers might be more confident today, leading to higher consumption.
• Wealth effect
  • Wealth refers to the stock of assets, such as housing, shares, savings, cars and so on.
  • A rise in house prices leads to an increase in wealth. So those with wealth feel more financially secure and spend more, increasing consumption.

Investment

Investment (I) is the total spending by firms on goods and services.

Net investment = (gross) investment – depreciation.

Depreciation refers to wear and tear, which lowers the value of capital over time.

What determines the level of investment?

• Economic growth rate or business expectations / confidence
  • Rising economic growth rate ⇨ higher expected future demand ⇨ higher investment in capital today to meet higher expected future demand and increase future profits.
  • Similarly, business expectations of higher future demand may lead to higher investment in capital today.
• Animal spirits
  • Animal spirits refer to emotions that affect investor choices.
  • Herd behaviour means individuals may make decisions influenced by the behaviour of a larger group. For instance, if a group of investors invest in a speculative asset, this may encourage others to invest in that same asset.
  • Investors may be overconfident about the success of investments. This could be because of herd behaviour.
  • Herd behaviour or overconfidence⇨ higher perceived probability of investment success ⇨ higher investment today.
• Interest rates
  • Higher interest rates  ⇨ higher cost of borrowing ⇨ lower borrowing to fund investment ⇨ lower investment.
  • stricter access to credit (for instance, if banks introduce tougher requirements to lend money) ⇨ lower borrowing to fund investment ⇨ lower investment.
• Access to credit
  • Credit refers to methods to defer payment. This includes borrowing money through loans, buy now pay later schemes or credit cards.
  • Stricter access to credit (for instance, if banks introduce tougher requirements to lend money) ⇨ lower borrowing to fund investment ⇨ lower investment.
• Changes to profit levels
  • Higher profits mean firms have more funds available for investment, so investment rises.
  • Higher profits could occur for multiple reasons, including lower corporation taxes or higher export demand.
    • Corporation tax is a tax on profits. A fall in corporation tax rates may increase profits.
    • Higher export demand would increase firm revenues which may increase firm profits.
• Stricter regulation ⇨ higher  firm costs ⇨ lower profits ⇨ reduced funds to use for investment ⇨ lower investment .

Government spending

Government spending (G) = total government expenditure on goods and services.

What influences the level of government spending?

• Trade cycle (also known as the business cycle):
  • For example, a positive output gap ⇨ lower unemployment ⇨ lower welfare spending on unemployment benefit ⇨ ↓ G.
• Fiscal policy
  • A Keynesian policy involves increasing G in downturns, lower G in booms.
  • Some politicians may want to increase the size of government, for instance to provide higher quality public services, leading to higher government spending.
  • Conversely, other politicians may prefer to shrink the size of government, in order to lower tax rates. This would lead to lower government spending.
  • Politicians might increase government spending in the run-up to elections, to grow the economy and win votes.

Net exports

Key influences:

• Real income rising  ⇨ higher import demand ⇨ higher imports ⇨ lower net exports and lower AD.
• Exchange rate = value of one currency in terms of another.
  • A depreciation is a fall in currency value relative to another currency.  
  • Depreciation ⇨  exports cheaper, imports dearer ⇨  higher export demand and lower import demand ⇨ possible rise in total value of net exports. So AD rises. 
• More protectionism (tariffs – taxes on imports) make imports dearer, so the quantity of imports fall. So import spending may rise, so AD falls.
• Global downturn ⇨ ↓ global incomes ⇨ ↓ export demand and (X-M).
• Higher relative export quality or improved relations with other countries can also increase exports and AD.

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