8.2 - Aggregate Demand
The components of aggregate demand
Aggregate demand (AD) represents the overall spending or demand in an economy during a specific timeframe. It includes all types of expenditure that contribute to economic activity.
Formula for calculating aggregate demand
Where:
- Consumption (C) = Total spending by households on goods and services
- Investment (I) = Spending by firms on assets for production
- Government spending (G) = Expenditure on public goods and services
- Exports (X) = Goods and services sold abroad
- Imports (M) = Goods and services bought from abroad
Key features of aggregate demand components
Consumption:
- Forms over 60% of AD in the UK, making it the biggest part.
- Increases in this component boost AD, while decreases reduce it.
- Households either spend income on consumption or save it; high consumption often means low saving, and the reverse is also true.
Investment:
- Accounts for about a fifth of AD in the UK.
- It focuses on purchases by firms, such as machinery or buildings, to generate future profits.
- Gross investment covers all such spending, while net investment only counts additions that expand production capacity.
Government spending:
- Includes direct spending on areas like education, healthcare, and defence.
- Excludes transfers such as benefits or pensions.
Net exports:
- Calculated as exports minus imports, this is usually a small share of AD.
- Exports add to the economy as injections, while imports act as withdrawals.
Factors influencing consumption and saving
Consumption refers to household spending on goods and services, excluding business purchases. It has a major effect on AD due to its large share. Saving occurs when income is not spent, creating an inverse relationship with consumption.
Influences on household consumption and saving
- Income levels - Higher disposable income boosts consumption, though the increase is often smaller than the income rise as people save more.
- Interest rates - Elevated rates encourage saving over spending, reduce borrowing, and cut disposable income through higher loan repayments.
- Consumer confidence - Strong economic outlooks lead to more spending and less saving; in downturns, people cut back on purchases.
- Wealth changes - Increases in assets like property or shares build confidence, raising consumption and lowering saving.
- Taxation - Higher direct taxes reduce available income for spending; indirect taxes make goods costlier, discouraging consumption.
- Unemployment rates - Rising joblessness prompts more saving and less spending; falling rates increase overall expenditure as more people earn wages.
Factors affecting investment
Investment involves firms buying assets like equipment or premises to produce goods and services. It differs from saving, which is mainly done by households (e.g., bank deposits), while investment is firm-led (e.g., building a factory).
Influences on business investment decisions
- Risk levels - Greater economic uncertainty discourages investment as firms fear lower returns.
- Government incentives - Measures like subsidies or tax cuts make projects more attractive and increase investment.
- Regulatory environment - Easing rules can lower costs, encouraging firms to invest.
- Interest rates - High rates raise borrowing costs, reduce project profitability, and make saving funds in banks more appealing than investing.
- Technological progress - Firms must invest in new tools to stay competitive and efficient.
- Business confidence - Positive expectations about the economy lead to higher investment.
- Animal spirits - Investment choices are not always logical; emotions, instincts, and optimism, as noted by economist John Maynard Keynes, play a role.
Government spending and fiscal policy
Government spending covers expenditure on public services that directly add to economic output. It forms a key part of AD, with changes having wide-reaching effects.
Features of government budgets and fiscal policy
- Budget outcomes - A budget deficit occurs when spending outstrips revenue; a surplus happens when revenue exceeds spending.
- Fiscal policy tools - Governments adjust spending and taxes to manage AD. In slow growth periods, they may run deficits to stimulate demand; during booms, higher taxes and lower spending can cool the economy.
- Impact on circular flow - Deficits inject money into the economy, boosting activity; surpluses withdraw funds, potentially slowing growth.
- Long-term considerations - Persistent surpluses might limit expansion, while ongoing deficits can build up national debt.
Influences on net exports
Net exports are the difference between exports (domestic goods sold overseas) and imports (foreign goods bought domestically). Exports inject funds into the economy, while imports withdraw them. If imports exceed exports, net exports become negative.
Factors determining net exports
- Exchange rates - Over time, a stronger currency harms net exports by cheapening imports and raising export prices. Short-term, a currency rise can briefly improve net exports as values adjust before quantities change.
- Domestic income - Higher earnings increase import demand, reducing net exports.
- Global economic conditions - Strong growth in trading partners boosts demand for exports.
- Protectionist measures - Tariffs or quotas can raise net exports initially but may harm efficiency and provoke trade disputes in the long run.
- Product quality - Superior goods attract exports, as buyers pay more for premium items.