Aggregate demand

Aggregate demand (AD) is the total demand for goods and services produced within the economy over a period of time.

Aggregate demand (AD) is composed of various components.

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

  • C = Consumer expenditure on goods and services.
  • I = Gross capital investment – i.e. investment spending on capital goods e.g. factories and machines
  • G = Government spending e.g. spending on NHS, education. Note transfer payments in the form of pensions and unemployment benefits are not included because they are not related to output produced.
  • X = Exports of goods and services. Goods leave the country but money from abroad flows into the economy. Therefore this is an increase in AD (an injection into the circular flow)
  • M = Imports of goods and services, although goods enter the country money is leaving the economy to go to other countries. Therefore AD falls.

AD slopes downwards because

ad-downward-sloping

  • At a lower price level, people are able to consume more goods and services, because their real income is higher.
  • At a lower price level, interest rates usually, fall causing increased AD.
  • At a lower price level, exports are relatively more competitive than imports.

Shifts in the aggregate demand curve

increase-ad-inflation-growth-for-PC

 

Graph to show increase in AD

An increase in AD (shift to the right of the curve) could be caused by a variety of factors

1. Increased consumption:

  • An increase in consumers wealth (higher house prices or value of shares)
  • Lower Interest Rates which makes borrowing cheaper, therefore, people spend more on credit cards. Also, mortgage payments are cheaper which gives people more disposable income.
  • Higher wages
  • Lower Taxes
  • Increased consumer confidence about the future

Consumer expenditure accounts for about 66% of AD and therefore is a very important component of AD

2. Increased Investment

  • Lower interest rates, this makes borrowing for investment cheaper.
  • Increased confidence in the economic outlook
  • Improved technology
  • Increased economic growth, to meet increased demand firms need to increase capacity

3. Increased G

  • Government pursues expansionary fiscal policy
  • Government invests in infrastructure

4. Increased X

  • The UK more competitive, for example, an increase in labour productivity would make the UK more competitive
  • Increased growth in other countries, therefore they will have higher demand
  • Lower value of Sterling, this makes exports cheaper

5. Decreased M

  • The UK more competitive, this makes goods from other countries appear less competitive.
  • Lower value of Sterling, this makes imports more expensive
  • Lower GDP, therefore consumers will have less money to spend.

Fall in AD

fall-in-ad-arrow-ad-as

In this diagram, we see a fall in AD. This causes a fall in real GDP and a fall in the price level (P1 to P2)

fall-ad-full-capacity

In this diagram, the fall in AD has mainly caused a fall in the price level, with little change in real GDP.

fall-ad-depends-on-spare-capacity

 

Components of AD

AD

Components of aggregate demand as %

components-ad

A graph showing components of AD as a %

In the above charts, I left out two minor factors NPISH and change in inventories to make it simpler.

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By on November 28th, 2016 in