Aggregate Demand

Author: Geoff Riley  Last updated: Sunday 23 September, 2012

Introduction

Aggregate means ‘total’ and in this case we use the term to measure how much is being spent by all consumers, businesses, the government and people and firms overseas.

Aggregate demand (AD) = total spending on goods and services

AD = C + I + G + (X-M)

• C: Consumers' expenditure on goods and services : Also known as consumption, this includes demand for durables e.g. audio-visual equipment and motor vehicles & non-durable goods such as food and drinks which are “consumed” and must be re-purchased.
• I: Capital Investment – This is spending on capital goods such as plant and equipment and buildings to produce more consumer goods in the future. Investment also includes spending on working capital such as stocks of finished and semi-finished goods.
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• Capital investment spending in the UK accounts for between 16-20% of GDP in any given year. Of this investment, 75% comes from private sector businesses such as Tesco, British Airways and British Petroleum and the remainder is spent by the government – for example building new schools or in improving railway or road networks. So a mobile phone company such as O2 spending £100 million on extending its network capacity and the government allocating £15 million of funds to build a new hospital are both capital investment. Investment has important effects on the supply-side as well as being an important component of AD. A small part of investment spending is the change in the value of stocks –i.e. unsold products. Producers may find either than demand is running higher than output (i.e. stocks will fall) or that demand is weaker than expected and less than current output (in which case the value of unsold stocks will rise.)

• G: Government Spending – This is spending on state-provided goods and services including public goods and merit goods . Decisions on how much the government will spend each year are affected by developments in the economy and the political priorities of the government.
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• Government spending on goods and services is around 18-20% of GDP but this tends to understate the true size of the government sector in the economy. Firstly some spending is on investment and a sizeable slice goes on welfare state payments. Transfer payments in the form of benefits (e.g. state pensions and the job-seekers allowance) are not included in current government spending because they are a transfer from one group (i.e. people in work paying income taxes) to another (i.e. pensioners drawing their state pension having retired from the labour force, or families on low incomes).
• X: Exports of goods and services - Exports sold overseas are an inflow of demand (an injection) into our circular flow of income and spending adding to aggregate demand.
• M: Imports of goods and services. Imports are a withdrawal of demand (a leakage) from the circular flow of income and spending.
• Net exports measure the value of exports minus the value of imports. When net exports are positive, there is a trade surplus (adding to AD); when net exports are negative, there is a trade deficit (reducing AD). The UK has been running a large trade deficit for several years now.

Aggregate Demand in the UK Economy

All of the data above is expressed in £ billion at constant prices

Source: Office for National Statistics, Economic Trends 2011

The main components of aggregate demand are shown in the table above
Remember that
AD = C + I + G + X – M

The change in the value of stocks is a small component of the equation, it relates to changes in how much investment businesses are making in stocks (unsold products) to be consumed at a later stage.

• Recession: 2009 was a year of recession – what happened to each of the components of aggregate demand in 2009 compared to 2008?
• Recovery: The British economy started to recover in 2010; using the table can you explain why this happened?
  

Shocks to aggregate demand

• Many unexpected events can happen which causes changes in the level of demand, output and employment
• Headwinds can alter direction with great speed leading to uncertainty about where the economy is heading
• These events are called “shocks”. Some of the causes of AD shocks are as follows:
• A big rise or fall in the exchange rate – affecting export demand and having follow-on effects on output, employment, incomes and profits of businesses linked to export industries.
• A recession in one or more of our main trading partners which affects demand for our exports of goods and services.
• A slump in the housing market or a big change in share prices.
• An event such as the credit crunch (global financial crisis) – involving a fall in the amount of credit available for borrowing by households and businesses.
• An unexpected cut or an unexpected rise in interest rates or change in government taxation and spending – for example the shock of deep cuts in state spending expected in 2011 and beyond.

These shocks will bring about a shift in the aggregate demand curve – and we turn to this next.

The Aggregate Demand Curve

The AD curve shows the relationship between the general price level and real GDP.

Aggregate Demand and the Price Level

There are several explanations for an inverse relationship between AD and the price level in an economy. These are summarised below:

• Falling real incomes: As the price level rises, so the real value of people’s incomes fall and consumers are less able to buy the items they want or need. If over the course of a year all prices rose by 10 per cent whilst your money income remained the same, your real income would have fallen by 10%
• The balance of trade: A persistent rise in the price of level of Country X could make foreign-produced goods and services cheaper in price terms, causing a fall in exports and a rise in imports. This will lead to a reduction in net trade and a contraction in AD
• Interest rate effect: if the price level rises, this causes inflation and an increase in the demand for money and a consequential rise in interest rates with a deflationary effect on the economy. This assumes that the central bank (in our case the Bank of England) is setting interest rates in order to meet a specified inflation target

Shifts in the AD Curve

• A change in the factors affecting any one or more components of aggregate demand i.e. households (C), firms (I), the government (G) or overseas consumers and business (X) changes planned spending and results in a shift in the AD curve.

Consider the diagram below which shows an inward shift of AD from AD1 to AD3 and an outward shift of AD from AD1 to AD2. The increase in AD might have been caused for example by a fall in interest rates or an increase in consumers’ wealth because of rising house prices.

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