2. What is Aggregate Demand
• Defined as:
• Amounts of Real Output
• Buyers collectively desire at
each possible price level
• AD is the total demand for an
economy’s goods & services.
• The identity for calculating
aggregate demand (AD) is as
follows:
• AD = C + I + G + (X-M)
• Where:
C: Household
spending/consumption
I: Capital Investment spending
G: Government spending
X: Exports of Goods and Services
M: Imports of Goods and Services
3. Aggregate Demand
• C: Consumers' expenditure on goods and services:
This includes demand for consumer 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).
Household spending accounts for over sixty five per cent
of aggregate demand in the UK.
• I: Capital Investment – This is investment spending by
companies on capital goods such as new plant and
equipment and buildings. Investment also includes
spending on working capital such as stocks of finished
goods and work in progress.
4. Aggregate Demand
• G: Government Spending – This is government spending on state-
provided goods and services including public and merit goods. Decisions on
how much the government will spend each year are affected by
developments in the economy and also the changing political priorities of
the government. In a normal year, government purchases of goods and
services accounts for around twenty per cent of aggregate demand. We will
return to this again when we look at how the government runs its fiscal
policy.
• Transfer payments in the form of welfare benefits (e.g. state pensions and
the job-seekers allowance) are not included in general government
spending because they are not a payment to a factor of production for any
output produced. They are simply a transfer from one group within the
economy (i.e. people in work paying income taxes) to another group (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 in goods and services between the UK economy and the rest of the
world.
5. Aggregate Demand
• X: Exports of goods and services - Exports sold overseas are an
inflow of demand (an injection) into our circular flow of income and
therefore add to the demand for UK produced output.
• M: Imports of goods and services. Imports are a withdrawal of
demand (a leakage) from the circular flow of income and spending.
Goods and services come into the economy for us to consume and
enjoy - but there is a flow of money out of the economy to pay for
them.
• Net exports (X-M) reflect the net effect of international trade on the
level of aggregate demand. 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 economy has been running
a large trade deficit for several years now as has the United States.
6. Capital Investment and
Spending
• Investment is spending by UK firms on capital goods such as new factories,
plant or buildings, machinery & vehicles. Firms can also plan to save if they
retain profit without spending it. We assume that, households make saving
decisions & firms make investment decisions.
• Definition of Capital Investment
• Capital investment is defined as spending on capital goods such as new
machinery, buildings and technology so that the economy can produce
more consumer goods in the future.
• A broader definition of investment would encompass spending on
improving the human capital of the workforce - for example extra
investment in training and education to improve the skills and
competences of workers.
• Most economists agree that investment is vital to promoting long-run
economic growth through improvements in productivity and a country’s
productive capacity.
7. Key Factors Determining Capital
Investment Spending
• Real interest rates: Interest rates affect the cost of borrowing money to finance investment. If the rate of interest
increases, the cost of funding investment increases, reducing the expected rate of return on capital projects. A
second factor is that higher interest rates raise the opportunity cost of using profits to finance investment – i.e. a
business might decide that the cost of financing new capital is too high and that it could earn a higher rate of return
by simply investing the cash. Low interest rates are not always good news for business investment. Recently
economists have become concerned that low interest rates has reduced the cost of capital for businesses to such
an extent that some low quality capital investment projects have been given the go ahead and much of this
investment has proved to be disappointing.
• The rate of growth of demand: Investment tends to be stronger when consumer demand is rising, giving
businesses an extra incentive to invest to expand their capacity to meet this demand. Higher expected sales also
increase potential profits – in other words, the price mechanism should allocate extra funds and factor inputs
towards investment goods into those markets where consumer demand is rising.
• Corporate taxes: Corporation tax is paid on profits. If the government reduces the rate of corporation tax (or
increases investment tax-allowances) there is a greater incentive to invest. Britain has relatively low rates of
company taxation compared to other countries inside the EU. This is a factor that helps to explain why Britain has
been a favoured venue for inward investment from overseas during the last decade.
• Technological change and degree of market competition: In markets where technological change is rapid,
companies may have to commit themselves to higher levels of investment to keep pace with the shifting
frontier of technology and remain competitive. In markets where there is a premium on a business keeping costs
down but at the same time, achieving year on year gains in efficiency and quality of service, there is also an
incentive to keep capital investment spending high.
• Business confidence: Business confidence can be vital in determining whether to go ahead with an investment
project. When confidence is strong then planned investment will rise. The Confederation of British Industry
(www.cbi.org.uk) publishes a quarterly survey of confidence that gives economists an insight into likely trends in
investment from manufacturing industry – although it must be remembered that over 70% of total GDP now comes
from the service sector. In recent years, capital spending by service businesses has grown strongly – but
manufacturing investment has weakened.
8. Consumption & Saving
• Consumption is a macroeconomic
concept, representing total planned
spending on consumer goods & services
by all households in the economy.
• Saving is the amount of expected income
that households do not plan to spend on
consumption.
• S = Y- C
9. Key factors that determine
consumer spending in the economy
• The level of real disposable household
income
• Interest rates and the availability of credit:
The rate of interest is the reward for saving. The higher the ROI, the greater the reward for
saving., so more of income is saved. It follows that if saving increases at higher rates of
interest, consumption must fall.
• Consumer confidence
• Changes in household financial wealth
• Changes in employment and
unemployment
10. How does saving affect the
circular flow of income?
• Along with taxation and spending on imports, saving is a leakage or withdrawal from
the circular flow of income. By contrast, investment by firms (along with government
spending and spending by overseas residents on the country’s exports) is an injection
into the circular flow.
• Households may, of course, plan to save more than firms plan to borrow to finance
investment decisions. In this situation {and provided we assume that:
G = T and X = M (government expenditure & Net Taxes) and that these
relationships do not change}, pre—Keynesian (neoclassical) theory assumed the
rate of interest rises or falls until planned saving equals planned investment.
• By contrast, in Keynesian theory, it is the level of output or income circulating
around the economy that adjusts to bring about equality between saving and
investment plans. This brings us to the essentially Keynesian argument that when
households plan to save too much, the level of output falls, until in recessionary
conditions the lower level of output induces the fall in saving required to restore the
equality between saving and investment plans. This illustrates the paradox of thrift,
or the view that saving is a virtue at the individual level, but a vice at the macro or
aggregate level, if everybody saves too
12. AD & AS
Aggregate demand is the quantity of goods and
services that people are willing to buy at a given
level of prices or total demand of an economy’s
goods & services.
• Aggregate Supply is the total value of goods &
services that an economy can produce in a
given period of time.
13. Macroeconomic Equilibrium
• Equilibrium (and its opposite disequilibrium) are two of
the most important concepts in economics.
• lt is useful to think of equilibrium as a state of balance or
a state of rest that occurs when opposing forces are
equal. And just as a microeconomic market (for example,
the market for bread) is in equilibrium when planned
demand equals planned supply, so the macro
economy is in equilibrium when aggregate demand
equals aggregate supply.
• Macro-economic equilibrium is established when AD
intersects with SRAS
14. This is shown in the diagram below. At price level P1, AD is equal to SRAS – i.e. at this price level, the
value of output produced within the economy equates with the level of demand for goods and
services. The output and the general price level in the economy will tend to adjust towards this
equilibrium position. If the general price level is too high for example, there will be an excess supply of
output and producers will experience an increase in unsold stocks. This is a signal to cut back on
production to avoid an excessive level of inventories. If the price level is below equilibrium, there will
be excess demand in the short run leading to a run down of stocks – a signal for producers to expand
output.
15. Aggregate Supply.
• Aggregate supply (AS) is defined as the
total planned supply of goods and services
sold by entrepreneurs and other economic
agents in the economy. The short—run
aggregate supply (SRAS) curve slopes
upward, showing that firms are only willing
to increase the supply of goods and
services if the price level rises.
16. Short-run and Long-run
Aggregate Supply
• Short run aggregate supply (SRAS) shows total planned output
when prices in the economy can change but the prices and
productivity of all factor inputs e.g. wage rates and the state of
technology are assumed to be held constant.
• Long run aggregate supply (LRAS): LRAS shows total planned
output when both prices and average wage rates can change –
it is a measure of a country’s potential output and the concept is
linked strongly to that of the production possibility frontier
• In the long run, the aggregate-supply curve is assumed to be
vertical
• In the short run, the aggregate-supply curve is assumed to be
upward sloping
18. Multiplier Effect
• Multiplier
The multiplier effect is the proportion by which an
initial increase in injections (G, I or X) causes a
greater final increase in the level of national income.
An initial change in aggregate demand can have a
much greater final impact on the level of equilibrium
national income. This is commonly known as the
multiplier effect and it comes about because injections
of demand into the circular flow of income stimulate
further rounds of spending – in other words “one
person’s spending is another’s income” – and this can
lead to a much bigger effect on equilibrium output and
employment.
19. • The Multiplier and Keynesian Economics
• The concept of the multiplier process became important in the 1930s when John Maynard
Keynes suggested it as a tool to help governments to achieve full employment. This
macroeconomic “demand-management approach”, designed to help overcome a shortage of
business capital investment, measured the amount of government spending needed to reach a
level of national income that would prevent unemployment.
• The higher is the propensity to consume domestically produced goods and services, the
greater is the multiplier effect. The government can influence the size of the multiplier through
changes in direct taxes. For example, a cut in the basic rate of income tax will increase the
amount of extra income that can be spent on further goods and services.
• Another factor affecting the size of the multiplier effect is the propensity to purchase imports.
If, out of extra income, people spend money on imports, this demand is not passed on in the
form of extra spending on domestically produced output. It leaks away from the circular flow of
income and spending.
20. Accelerator Effect
• Planned capital investment by private sector businesses is linked to the growth of demand for goods
and services. When consumer or export demand is rising strongly, businesses may increase
investment to expand their production capacity and meet the extra demand. This process is
known as the accelerator effect. But the accelerator effect can work in the other direction! A
slowdown in consumer demand can create excess capacity and may lead to a fall in planned
investment demand.
• Conversely, a fall in consumer demand will also lead to a fall in capital investment. Because of the
nature of investment (capital goods tend to last for a number of years and are therefore expensive),
the level of investment will tend to be greater than the initial change in demand that stimulated the
decision to increase capacity.
lf the rate of growth of national income is increasing then investment will rise by a multiple of this
growth rate.
lf the rate of growth of national income is decreasing then investment will fall.
lf national income is constant then only replacement investment will take place.
lf national income falls then there will be no investment.
• A good example of this in recent years is the telecommunications industry. Capital investment in this
sector surged to record highs in the second half of the 1990s, driven by a fast pace of technological
advance and huge increases in the ICT budgets of corporations, small-to-medium sized businesses,
and extra capital investment by the public sector (including education and health).
• The telecommunications industry invested giant sums in building bigger and faster networks, but
demand has slowed in the first three of the decade, leaving the industry with a vast amount of spare
capacity (an under-utilisation of resources). Capital investment spending in the telecommunications
industry has fallen sharply in the last three years – the accelerator mechanism working in reverse.
