2.3.2 - Aggregate demand (AD)
- Syllabus
- 2018
- Topic
- 2.3.2
- Level
- AS
Learning objectives
2.3.21a - concept of AD. characteristicsThe concept of AD. characteristics2.3.21b - Components of aggregate demand: of AD • C + I + G + (X-M) = • the AD curveComponents of aggregate demand: of AD; C + I + G + (X-M) =; the AD curve.2.3.21c - distinction between a movement along, and a shift of, the AD curveThe distinction between a movement along, and a shift of, the AD curve.2.3.22a - Influences on consumption: • disposable income • interest rates • consumer confidence •Influences on consumption:; disposable income; interest rates; consumer confidence; level of welfare payments; wealth effects; availability of credit.2.3.22b - relationship between savings and consumptionThe relationship between savings and consumption.2.3.22c - definition of the 'savings ratio'The definition of the 'savings ratio'.2.3.22d - Causes and effects of changes in the savings ratioCauses and effects of changes in the savings ratio.2.3.23a - distinction between gross investment and net investmentThe distinction between gross investment and net investment.2.3.23b - Influences on investment: • the rate of economic growth • interest rates • businessInfluences on investment:; the rate of economic growth; interest rates; business confidence and expectations; availability of credit; tax on company profits.2.3.23c - Government policy to promote investment: • tax relief • subsidies • reductions on theGovernment policy to promote investment:; tax relief; subsidies; reductions on the rate of corporation tax.2.3.24a - Influences on government expenditure: expenditure (G) • fiscal policy • the level ofInfluences on government expenditure: expenditure (G); fiscal policy; the level of economic activity; correction of market failures; political priorities.2.3.25a - impact on the net trade balance of changes in: (X-M) • real income • the exchange rateThe impact on the net trade balance of changes in: (X-M); real income; the exchange rate; the state of the global economy; degree of protectionism; non-price factors.
What aggregate demand measures
Aggregate demand (AD) is total planned expenditure on domestically produced final goods and services at each average price level in a given period.
The AD curve slopes downward in price-level/real-output space: a lower price level raises the real value of money balances, can reduce interest-rate pressure and makes domestic output relatively competitive, increasing planned real expenditure.
AD is economy-wide planned expenditure, not demand for one product. Its vertical axis is the average price level and its horizontal axis is real output.
Components of aggregate demand
AD=C+I+G+(X−M): household consumption, investment, government expenditure and net exports.
| Component | Included spending |
|---|---|
| C | household spending on final goods and services |
| I | firms' capital spending and relevant inventory change |
| G | government purchases of goods and services |
| X−M | exports minus imports; imports are subtracted because they are not domestic output |
To find a missing component, rearrange the identity and preserve the sign of net exports. Savings, taxes and transfers are not added as separate AD components.
The AD curve shows a value of total planned expenditure at every price level; one calculated AD total is a point for a particular period, not the whole curve.
Movement along or shift of AD
| Change | Diagram response |
|---|---|
| average price level changes, other determinants fixed | movement along the existing AD curve |
| any non-price determinant changes C, I, G or X−M | entire AD curve shifts |
Higher consumption, investment, government expenditure or net exports shifts AD right; lower planned expenditure shifts it left.
A rise in the price level does not shift AD. It produces a contraction along AD unless it independently changes a non-price determinant.
What changes consumption
| Influence | Usual effect on consumption, other things equal |
|---|---|
| disposable income | higher income available after direct tax and transfers raises consumption |
| interest rates | higher rates raise borrowing cost and reward saving, reducing consumption |
| consumer confidence | optimism about income/jobs encourages current spending |
| welfare payments | higher transfers raise recipients' disposable income |
| wealth effects | rising asset values can raise perceived wealth and spending |
| availability of credit | easier borrowing relaxes current spending constraints |
State the determinant, its effect on disposable resources/incentives/confidence, the change in consumption and therefore the direction of AD.
Wealth is a stock, not current income. House-price gains affect spending through confidence, collateral and perceived wealth; they do not automatically provide cash to every homeowner.
Saving and consumption
Disposable income is either consumed or saved: Yd=C+S. Therefore S=Yd−C for a given period.
With disposable income fixed, more saving means less consumption and more consumption means less saving. When income changes, consumption and saving can both rise, so the relationship is not always a one-for-one movement in observed totals.
Because consumption is part of AD and saving is a withdrawal from the circular flow, a rise in saving at unchanged income tends to reduce AD in the short run.
Saving can finance future investment through financial markets, but household saving is not itself the I component of current AD.
The savings ratio
The savings ratio is the percentage of household disposable income not spent on consumption.
savings ratio=household saving/household disposable income×100.
If disposable income is 50,000andconsumptionis46,000, saving is 4,000andthesavingsratiois4,000/50,000×100=8%.
A rise from 5% to 8% is an increase of 3 percentage points, not 3%. The ratio can change because saving, disposable income or both change.
Why the savings ratio changes
| Change | Likely savings-ratio response |
|---|---|
| higher interest rates | reward for saving rises and borrowing becomes dearer: ratio may rise |
| recession/job insecurity | precautionary saving may raise the ratio, though lost income can constrain saving |
| stronger confidence | households may save less and consume more |
| rising wealth/credit availability | consumption may rise relative to income, lowering the ratio |
| demographic or pension expectations | desired provision for future income changes |
A higher ratio usually lowers current consumption, shifts AD left and increases withdrawals; a lower ratio usually raises consumption, shifts AD right and may raise real output and the price level.
Ceteris paribus matters. A higher ratio does not prove total saving rose if disposable income fell sharply, and its long-run effect depends on whether saving finances productive investment.
Gross and net investment
| Measure | Meaning |
|---|---|
| gross investment | all spending that adds to or replaces capital during the period |
| depreciation | value of capital used up or becoming obsolete |
| net investment | gross investment minus depreciation; the addition to productive capital stock |
net investment=gross investment−depreciation. Positive net investment expands the capital stock; zero maintains it; negative means depreciation exceeds gross investment.
Replacement spending counts in gross investment but does not increase net capital stock.
What changes business investment
| Influence | Investment mechanism |
|---|---|
| economic growth | stronger expected sales encourage capacity expansion (accelerator effect) |
| interest rates | higher borrowing/opportunity cost reduces projects with positive expected return |
| confidence and expectations | stronger expected demand/profit raises willingness to commit irreversibly |
| credit availability | lending access determines whether viable projects can be financed |
| tax on company profits | higher tax can reduce after-tax return and retained funds |
Investment depends on expected return relative to financing cost, so one influence may be outweighed by uncertainty, spare capacity or weak demand.
Investment here means capital spending, not buying existing shares or saving money in a bank account.
Policies that promote investment
| Policy | Transmission |
|---|---|
| investment tax relief | reduces tax payable on qualifying capital spending, increasing after-tax return |
| investment subsidy | lowers the effective purchase cost of capital |
| lower corporation-tax rate | raises expected retained/after-tax profit and internal finance |
If firms respond, investment raises AD immediately and can expand productive capacity and LRAS later. The size depends on confidence, demand, credit, policy credibility and project eligibility.
Tax relief or subsidy has fiscal opportunity cost and may reward investment that would have occurred anyway. A policy announcement is not proof of additional investment.
What changes government expenditure
| Influence | Spending channel |
|---|---|
| fiscal policy | discretionary expansion or contraction changes purchases |
| economic activity | downturns can raise welfare-related spending automatically; booms may reduce it |
| correction of market failure | public goods, merit goods, information or externality programmes require resources |
| political priorities | defence, health, education, infrastructure and distribution choices alter allocation |
Only government purchases of current goods/services and capital enter G directly in AD. Transfer payments influence AD indirectly when recipients consume.
Higher government expenditure as a share of GDP can reflect higher spending, lower GDP, or both.
What changes net trade
| Change | Likely effect on X−M, other things equal |
|---|---|
| higher domestic real income | imports rise, worsening net trade |
| higher foreign/global income | export demand rises, improving net trade |
| currency appreciation | exports dearer and imports cheaper, tending to worsen net trade |
| more foreign protectionism | domestic exports fall, worsening net trade |
| better relative quality/productivity/reliability | exports become more competitive, improving net trade |
Exchange-rate effects depend on demand elasticities, contracts, imported inputs and time lags. Values can initially respond differently from quantities.
Net trade is exports minus imports. A stronger currency does not mechanically worsen the balance if non-price competitiveness or global demand changes enough to offset it.