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AS Macroeconomics / International Economy

Aggregate Demand

This section gives you a platform for understanding issues such as inflation, economic growth and unemployment. Aggregate demand (AD) and aggregate supply (AS) analysis provides a way of illustrating macroeconomic relationships and the effects of government policy changes.

Aggregate Demand

The identity for calculating aggregate demand (AD) is as follows:

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

C: Consumers' expenditure on goods and services: This includes demand for consumer durables (e.g. washing machines, audio-visual equipment and motor vehicles & non-durable goods such as food and drinks which are “consumed” and must be re-purchased). Household spending accounts for over sixty five per cent of aggregate demand in the UK.

I: Capital Investment – This is investment spending by companies on capital goods such as new plant and equipment and buildings. Investment also includes spending on working capital such as stocks of finished goods and work in progress.

Capital investment spending in the UK typically accounts for between 15-20% 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 public (government) sector – for example investment by the government in building new schools or investment in improving the 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 counted as part of capital investment. Investment has important long-term effects on the s supply-side of the economy as well as being an important although volatile component of aggregate demand.

G: Government Spending – This is government spending on state-provided goods and services including public and merit goods. Decisions on how much the government will spend each year are affected by developments in the economy and also the changing political priorities of the government. In a normal year, government purchases of goods and services accounts for around twenty per cent of aggregate demand. We will return to this again when we look at how the government runs its fiscal policy.

Transfer payments in the form of welfare benefits (e.g. state pensions and the job-seekers allowance) are not included in general government spending because they are not a payment to a factor of production for any output produced. They are simply a transfer from one group within the economy (i.e. people in work paying income taxes) to another group (i.e. pensioners drawing their state pension having retired from the labour force, or families on low incomes).

The next two components of aggregate demand relate to international trade in goods and services between the UK economy and the rest of the world.

X: Exports of goods and services - Exports sold overseas are an inflow of demand (an injection) into our circular flow of income and therefore add to the demand for UK produced output.

M: Imports of goods and services. Imports are a withdrawal of demand (a leakage) from the circular flow of income and spending. Goods and services come into the economy for us to consume and enjoy - but there is a flow of money out of the economy to pay for them.

Net exports (X-M) reflect the net effect of international trade on the level of aggregate demand. 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 economy has been running a large trade deficit for several years now as has the United States.

Aggregate demand shocks

Economic events such as changes in interest rates and economic growth in the United States can have a powerful effect on other countries including the UK. This is because the USA is the world’s largest economy. 15 per cent of our exports go to the USA.

Lots of unexpected events can happen which cause changes in the level of demand, output and employment in the economy. These unplanned events are called “shocks” One of the causes of fluctuations in the level of economic activity is the presence of demand-side shocks.

Some of the main causes of demand-side shocks are as follows:

• A capital investment boom e.g. a construction boom to increase the supply of new houses or to build new commercial and industrial buildings.
• A rise or fall in the exchange rate – affecting net export demand and having follow-on effects on output, employment, incomes and profits of businesses linked to export industries.
• A consumer boom abroad in the country of one of our major trading partners which affects the demand for our exports of goods and services.
• A large boom in the housing market or a slump in share prices.
• An unexpected cut or an unexpected rise in interest rates.

The Aggregate Demand Curve

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

Why does the AD curve slope downwards?

There are several explanations for an inverse relationship between aggregate demand 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 then less able to afford UK produced goods and services.
• The balance of trade: As the price level rises, foreign-produced goods and services become more attractive (cheaper) in price terms, causing a fall in exports and a rise in imports. This will lead to a reduction in trade (X-M) and a contraction in aggregate demand.
• Interest rate effect: if in the UK the price level rises, this causes an increase in the demand for money and a consequential rise in interest rates with a deflationary effect on the entire 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 factors affecting any one or more components of aggregate demand, households (C), firms (I), the government (G) or overseas consumers and business (X) changes planned aggregate demand 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.