Aggregate Demand

Revision notes

In this section:
 Quick guide to this topic
 Aggregate Demand
 Components of Aggregate Demand
 Factors that affect Consumption
 Factors that affect Investment
 Factors that affect Government Spending
 Factors that affect Exports and Imports

Quick guide to this topic [back to top]:

 Demand is the number of units people are willing and able to buy of a particular product or
service at a given price (microeconomics).
 Aggregate Demand is the total value of goods and services that people are willing and able to
buy in an economy at a given price level (macroeconomics).
 A change in the price level causes a movement along (up or down) the aggregate demand
curve.
 A change in any other factor causes shifts (right or left) in the demand curve.
 The components of aggregate demand are Consumption, Investment, Government Spending,
Exports and Imports.
 The formula for aggregate demand is AD = C + I + G + (X – M).
 There are a variety of factors that affect Consumption & Investment, but four common factors
are Taxation, Interest Rates, Inflation and Confidence.

Aggregate Demand [back to top]:

In microeconomics, you learn that ‘demand’ means the number of units people are willing and
able to buy of a particular product (or service) at a given price. As the price of that product rises,
demand usually falls, and as the price of the product falls, demand usually rises. This can be
demonstrated in the diagram below; imagine that this particular product is currently being sold at
£10 and the current demand is 100 units. If the price rises to £13, then demand falls to 70 units,
and if the price falls to £5, then the demand rises to 150 units.
In macroeconomics, the concept is very similar. However, instead of looking at the demand for
one particular product or service, we look at the total demand for all goods and services in an
economy at different price levels. This is called ‘aggregate demand’, and the word ‘aggregate’
simply means ‘total’.

Let’s look at an aggregate demand (AD) curve diagram (macro) to see how it differs from a
microeconomic demand curve diagram:
 The vertical axis: Instead of being labelled ‘price’, the vertical axis is labelled ‘price level’. This
is because we are not looking at the actual price of one specific product, but the price of all
goods and services in an economy. For this reason, we are unable to put an actual figure on it
(e.g. £10), so we refer to the price level as P1, P2, P3, etc.
 The horizontal axis: Instead of being labelled ‘quantity demanded’ we are able to label the
horizontal axis in a number of ways. When you learn about The Circular Flow of Income, you
learn that the size of an economy can be measured in one of three ways; 1) National Output,
2) National Income, or 3) National Expenditure; and that all of these methods should
theoretically be the same as each other. Therefore, we are able to label the horizontal axis
with any one of these three things. We could also call it GDP, since GDP is a measure of
National Income. The term ‘real’ shows that GDP is actually changing once we have taken into
account the effects of inflation (if we failed to consider this, then we wouldn’t know if a rise in
GDP was due to consumers buying more things, or buying the same amount of things at higher
prices – i.e. output hadn’t really grown at all).

Apart from these differences in labelling the axes, the concept between micro and macro diagrams
is the same: As the price level in the economy rises (inflation), AD usually falls, and vice versa. This
can be demonstrated in the diagram above; imagine that this particular economy is currently
operating at a price level of P1, and the current GDP / Output is Y1. If the price level rises to P2,
then real GDP will fall to Y2, and of the price level falls to P3, real GDP will rise to Y3. The reason
for this is fairly simple; as products and services become more expensive across the economy,
households and firms cannot afford to buy as many of them with their income, and vice versa.
An important thing to consider here is the Latin term ‘ceteris paribus’. This term shows that when
we say that a rise in the price level causes GDP to fall, we assume that the price level rising is the
only change happening at the time, and that all other factors stays the same. The term ‘ceteris
paribus’ allows us to isolate and analyse individual factors that affect the economy.

So far, we have seen that a change in the price level can cause a movement along (up or down)
the AD curve. Everything else causes the AD curve to completely shift (to the left or right). This
distinction can be demonstrated in the two diagrams below:

The Components of Aggregate Demand [back to top]:

Aggregate demand (AD) is made up of five separate components, and can be demonstrated using
the following formula:

 C stands for Consumption. This refers to spending by households and is the largest component
of AD, accounting for somewhere between 60 – 65% of AD.
 I stands for Investment. This refers to spending by firms.
 G stands for Government Spending. This refers to spending by the government.
 X stands for Exports. This refers to UK goods and services that are sold abroad (and money is
injected into our economy).
 M stands for Imports. This refers to foreign goods and services that are brought into the UK
from abroad (and money leaks from our economy to pay for them).

A change in any one or more of these components can cause the AD curve to shift left or right
(unless it is caused by inflation; as we learnt before, this is the only thing that causes a movement
along the AD curve).

Factors that affect Consumption [back to top]:

Consumption refers to spending by households on goods and services. The level of consumption in
an economy is affected by a variety of factors, which include:

 Taxation
Remember that taxation is a withdrawal from the circular flow of income. Therefore, if taxes rise
(e.g. income tax), households get to keep less of their income for themselves to spend back in the
economy, so consumption falls, which in turn causes to AD fall and shifts left (assuming ceteris
paribus).

 Interest Rates
A change in interest rates can affect consumption in three ways;
 Lower interest rates mean that it becomes cheaper to pay back a bank loan, therefore,
households are more likely to get a bank loan (to buy large, durable goods such as a new
car);
 Lower interest rates mean that the cost of paying back a mortgage falls. If households have
to pay back less on their mortgage each month, then they have more disposable income
available to spend on other things;
 Lower interest rates reduces the incentive to put money into a savings account, because
the reward is poor. If households are not saving their money, they are spending it.
All three of these things combined will increase consumption, which in turn increases AD, which
shifts it to the right. Note that a change in interest rates affects the Average Propensity to
Consume (APC) vs Average Propensity to Save (APS) (which you will have learnt about in the
Circular Flow of Income); APC + APS = 1, so if interest rates fall, the APS falls, thus the APC rises.

 Inflation (the price level)

As the price level in the economy rises (inflation), households cannot afford to buy as many goods
and services with their income as before, therefore AD falls. Remember, this is the only factor that
causes a movement along (in this case, up) the AD curve. The concept of ceteris paribus is
important here, because we are assuming that the price level has risen, but that household
incomes (and all other factors) have remained the same. This is a really easy point to add into your
essays in order to show evaluation.

 Confidence (& expectations)

When households are confident about the future of the economy, they are likely to continue
spending their income in a positive way. However, when households are worried about the future
of the economy (e.g. perhaps some people think there might be a recession and they might lose
their job), they may cut back on their spending and delay buying expensive luxuries. This can have
a negative effect on AD and shift the curve to the left.

 Incomes
As ‘real’ incomes rise (e.g. through pay rises), households are able to afford to buy more goods
and services than before, so consumption rises, which in turn causes AD to rise and shift right. The
word ‘real’ here means that we must take into account inflation when looking to see if someone
has ‘really’ got a pay rise or not.
For example:
 Imagine you receive a pay rise from £100 per week, to £110 per week.
 At first glance, it appears that you have received a £10 / 10% pay rise, and you are very
happy!
 However, you read in the news that prices in the economy have gone up by 15%. Are you
still happy?
 The answer is ‘probably not’! Although you have received a ‘nominal’ pay rise of £10 /
10%, you haven’t received a ‘real’ pay rise at all. In fact, in real terms, you are worse off
because of the effects of inflation (so your consumption might fall).
Ceteris paribus is important again here, because if real incomes rise, but at the same time,
households are worried about a possible recession, then consumption may not rise at all, as
households lack confidence and hold on to their extra income just in case.

 The ‘wealth effect’

Income is different to wealth; income is the money you receive on a regular basis (e.g. £100 per
week from your job), whereas wealth is the money you have accumulated over time (e.g. you
might have worked for 20 years and own a car, a house, shares in a business, and have £2,000
saved in the bank). The ‘’wealth effect’ refers to the idea that when you become wealthier (or
even feel wealthier), you are more likely to spend (which increases consumption). For example, if
the value of your house and shares go up, it is likely to make you feel wealthier, even though you
haven’t actually sold these items and cashed in the money. Also, it is possible to use an asset such
as your house as ‘security’ to take out a bank loan (security means that if you can’t pay back the
loan, the bank can force you to sell the house to pay them back); and the more your house is
worth, the bigger the bank loan you can take out.

 Availability of credit
As we saw above, when interest rates are low, households are more likely to want to take out a
bank loan, because they are cheaper to repay. This causes consumption to rise, because
households use the additional income they receive from the bank loan to spend in the economy.
However, there are times when it is difficult to get a bank loan; for example, new rules may have
been introduced making it harder for people on low incomes to get one; or banks may lack
confidence about the future of the economy so want to reduce the risk of lots of people not being
able to pay back their loans. In these cases, consumption will fall because even though households
may want to borrow money, it is not available.
Factors that affect Investment [back to top]:
Investment refers to spending by firms. For example, firms might invest in new equipment,
vehicles, buildings and stock. Firms typically invest because they believe they will get a ‘return on
their investment’; i.e. a firm might buy £10,000 worth of stock because it believes it can sell the
stock for £30,000 and make a £20,000 profit. When firms invest, it increases the potential output
of an economy.

Some useful terms to consider in this section are:

 Gross Investment – The size / value of the original investment. For example, a firm may have
bought a new delivery van which cost £30,000.
 Net Investment – The size / value of the investment at this current time, after the effects of
‘depreciation’ have been taken into account. Using the same example as above; if a firm
bought a new van for £30,000 five years ago (gross investment), then they now own a van that
might only be worth £10,000 (net investment).
 Physical Capital – This relates to new buildings, equipment, machinery, etc.
 Human Capital – This relates to investment in workers; e.g. recruiting and training workers.
 Saving vs investment – Firms may choose to save money (e.g. retain profits for use in the
future) or invest money (e.g. spend on improving physical and human capital).

The level of investment in an economy is affected by a variety of factors, which include the
following (note that the first four factors here are exactly the same as consumption, in order to
make them easier to revise and remember):

 Taxation
One of the main taxes that affects firms is corporation tax. This is a tax on the profits of firms;
therefore, as it rises, firms have to pay more of their profits to the government and get to keep
less for themselves. This is likely to have a negative effect on investment, because firms often use
their past profits (‘retained profit’), to improve and expand in the future.

 Interest Rates
Lower interest rates means that it becomes cheaper to pay back a bank loan. Therefore, firms are
more likely to get a bank loan in order to improve and expand their business (e.g. to buy new
equipment and machinery). This results in an increase in investment, and therefore the AD curve
shifts right.

 Inflation (the price level)

As the price level in the economy starts to rise, land, labour and capital all become more expensive
to buy. Therefore, firms are less willing and / or able to buy them, which reduces the amount of
investment that takes place in an economy (so AD falls and shifts left).
 Confidence (& expectations)
When firms lack confidence about the future of the economy, they become less willing to risk
money by investing in new workers, machinery, vehicles and buildings. They may put off buying
these things until confidence returns, and so the level of investment in an economy falls. Keynes
referred to this as the ‘animal spirits’ of firms.

 The ‘accelerator’ effect

When firms see a rise in AD (or real GDP), they realise that they will need to react in order to cope
with the additional demand for their products or services. If they don’t react, then at some point,
they will have to turn customers away because they have reached full capacity and cannot make
any more products or services. Therefore, firms invest in order to create greater capacity, so that
they can keep up with an increase in AD. For example, they may hire new staff and buy new
machinery and buildings. The accelerator effect works in reverse too; a fall in GDP is likely to result
in a fall in investment.

 Government policy, regulations & activity

 Government Policy - The government has the ability to encourage (or discourage)
investment by firms. For example, the government may provide grants and tax breaks in
certain industries, or in areas of high unemployment, which encourages business activity
(thus investment).
 Government Regulation - The government may try to limit business activity by firms that
sell ‘demerit’ goods (e.g. tobacco) by introducing tough laws. Alternatively, the
government might try to stimulate business activity by relaxing laws in certain industries.
 Government Activity – one argument against government spending is that too much
government spending ‘crowds out’ the private sector; in other words, if the government
provides too may services and borrows too much money, then there is less ‘room’ for
private sector firms to provide services and less available cash for them to borrow from
banks (plus higher interest rates); thus the level of investment falls.

Factors that affect Government Spending [back to top]:

The government spends money on a variety of public services such as education, health, transport,
and social security.
Government spending can be broken down into two types:
 Capital expenditure – this is a one-off purchase that adds to the capital stock of the country;
for example, building a new school, road or hospital.
 Current expenditure – this is repeated, ongoing payments; for example paying the wages of
teachers and nurses.
The government funds its spending in two main ways:
 Taxation – we have a variety of taxes in the UK, such as Income Tax, Corporation Tax and VAT.
 Borrowing – the government often needs to spend more money on public services than it
receives in taxes in a year; when this happens, the government is said to be running a ‘budget
deficit’. A budget deficit has to be funded by borrowing money. Two problems with increased
government borrowing are a) a rise in the national debt – in 2018 the UK’s national debt was
 approx. £1.8bn (90% of GDP), and b) too much government borrowing can ‘crowd out’ private
sector investment (less funds available / higher interest rates for private sector firms).

The nature and level of government spending in an economy is largely dependent on the
government at the time, and their political or economic views. For example, a ‘right wing’
government might typically prefer to reduce spending on unemployment benefits, and a
government that subscribes to Keynesian economics (as opposed to classical economics), might
be more willing to increase government spending in times of recession.

Another factor that affects the level of government spending is the state of the economy at the
time (the ‘trade cycle’). For example, in times of recession, where there are large numbers of
unemployed people, it is inevitable that a government would have to spend more on
unemployment benefits. Similarly, unexpected crises such as war, floods, and disease, can
influence the nature and level of government spending.

Factors that affect Exports and Imports [back to top]:

 Inflation (the price level)
The important thing to remember here is that we are talking about relative inflation between
countries. Let’s say that inflation in France is 5%, and that in the UK it is 10%; sooner or later, the
price of goods and services in the UK is going to reach a point where UK consumers would prefer
to buy from France (increasing imports) and French consumers would prefer to stop buying from
the UK (reducing exports). The rise in imports would result in greater withdrawals from our
economy, and the fall in exports would reduce injections into our economy; these two things
combined would reduce AD.

 Exchange rates
Exchange rates are the rate at which you can buy one currency with another. Imagine that £1
currently buys $3 (US Dollars), and then that changes to £1 = $2; the UK Pound has become
‘weaker’ (it won’t get you as many US Dollars as before). In this example, imports from the US
would be likely to fall because it costs us more to buy them, and exports to the US would be likely
to rise because it costs them less to buy from us. This would reduce withdrawals, increase
injections, and overall would increase AD.

At this point, it is important to consider the concept of elasticity, and the effect that it will have on
the volume and value of imports and exports. You may have studied price elasticity of demand in
microeconomics; this refers to the idea that not all products react to a change in price in the same
way. For some products, a change in price has a relatively large effect on the quantity demanded
(elastic), whilst for others, a change in price has a relatively small effect on the quantity demanded
(inelastic).

A classic example to use here would be oil; imagine that the UK had to import ALL of its oil from
the US. Using the same figures as above, a fall in the value of the Pound against the US Dollar,
would make importing oil from the US more expensive. However, because oil is essential to the
running of our economy, there is likely to be very little effect on the amount (the volume) of oil we
import from the US (inelastic). But, the amount of money we spend as a country on importing oil
from the US (the value) is likely to rise, as we have to pay more for it. It is the value that we need
to consider when looking at the effects on AD. In this example, even though there might be little or
no change in the volume of oil we import (because it is inelastic), there would be a reasonably big
change in the value, which would cause AD to fall as more money leaks from the UK economy.

 Non-price factors (e.g. quality)

Price is often considered to be the most important factor when looking at the demand for imports
and exports, and we covered this in the previous two points on inflation and exchange rates.
However, there are many other factors that affect whether we buy a product or not. One of the
main ones is quality; for example, if the UK makes products of high quality, then demand for our
exports is likely to be good (even if prices rise through inflation and a strong Pound).

 The world economy

Even when UK products are competitively priced (because of low inflation and a weak Pound), and
made to a high quality standard, we might still struggle to export them if other economies around
the world are suffering from recession. This is especially true if those countries happen to be our
main trading partners.

 Protectionism
Protectionism refers to the actions that a government might take to protect domestic (UK) firms
from cheap foreign imports, thus saving domestic jobs. Protectionist methods include tariffs,
quotas and subsidies. So if the UK government imposes a tariff (an import tax) on cars from
Country X, then the price to import those cars into the UK rises, therefore you would normally
expect demand to fall (thus imports would fall). However, Country X might retaliate by imposing a
tariff on something we export to them, thus UK exports fall.