Revision: Aggregate Demand

The components of aggregate demand form of the core of much of the AS macroeconomics syllabus. Students need to understand the domestic and external components of demand and how changes in AD feed through to affect output, prices and employment. This revision note covers the basics on AD.

Aggregate demand measures total spending on goods and services. The identity for calculating aggregate demand (AD) is as follows:

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

Where

C: Consumers’ expenditure on goods and services: Also known as consumption, this includes demand for 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. Consumer spending is the biggest single component of aggregate demand and in the UK it is expected to fall by more than 3% this year as the recession extends its grip across millions of households.

I: Capital Investment – This is investment spending on capital goods such as new plant and equipment and buildings which will allow us to produce more consumer goods in the future. Investment also includes spending on working capital such as stocks of finished goods and work in progress. 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 investment in building new schools or 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 capital investment. Investment has important effects on the supply-side as well as being an important although volatile component of aggregate demand. Once again, investment will fall in 2009 because of the impact of the recession. A separate revision note on business investment is available here.

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. 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 (nearly £190 billion in 2007) 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 general 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).

The next two components of aggregate demand relate to international trade 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 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 as has the United States although there are signs that the trade deficit in both countries is now shrinking. And with sterling having fallen by more than 25% over the last year, there are hopes that a more competitive exchange rate will provide an export-led boost to the economy during 2009-2010.

A full set of AS macro revision notes is available here and our AS economics revision presentations can be found here