Aggregate Demand

Key Issues

• What is aggregate demand?• What are the components of aggregate demand?• What causes changes in aggregate demand?• How does a change in AD cause changes in

output, employment and prices?• Macroeconomic policy and aggregate demand

Key concepts

• Aggregate demand (AD)– The total level of planned real expenditure on UK produced goods

and services

• Aggregate demand curve– Shows the level of planned demand for real output consistent with

a particular price level

• Exports – Imports (X-M)– The net trade balance

– Trade surplus (X>M) – a net injection of demand

– Trade deficit (X<M) – a net leakage of demand

• Government spending (G)– Expenditure by central and local government on goods and

services (not including welfare benefits)

Understanding Aggregate Demand

• Aggregate Demand (AD) =– Total level of planned real expenditure on UK produced goods and

services

• The components of aggregate demand• Household Spending (C)• Gross Fixed Capital Spending (I)• Value of Change in Stocks (inventories) • Government Consumption (G)• Exports of Goods and Services (X)• (minus) Imports of Goods and Services (M)

• AD sums to GDP (expenditure based)

Components of aggregate demand

Consumer spending is the biggest single component of aggregate demand

The UK Economic Cycle

Changes in the level of aggregate demand are key to understanding short term changes in a country’s economic cycle

The Aggregate Demand Curve

Real National Output

Price Level

AD1

P1

Y1

P2

Y2

Contraction along AD curve

The Aggregate Demand Curve

Real National Output

Price Level

AD1

P1

Y1

P2

Y2

P3

Y3

Expansion along AD curve

Outward Shift in AD

RNO

Price Level

AD1

P1

Y1 Y2

AD2

Outward shift of AD curve

Inward Shift in Aggregate Demand

Real National Output

Price Level

AD4

P1

Y4 Y3

AD3

Inward shift of AD curve

Some Causes of Changes in AD

Monetary Policy• Higher or lower interest rates• Change in supply of money• Change in a country’s exchange rate

Fiscal Policy• Changes in direct / indirect taxes• Changes in government spending• Changes in government borrowing

Business and Consumer confidence• Planned investment spending• Consumer confidence and retail spending

UK Policy Interest Rates

Falling interest rates – which in theory ought to bring about an increase in aggregate demand

Sterling against the US dollar ($)

A depreciation in the value of the £ v the US $

Sterling has been stable against the $ since 2010

Some Causes of Changes in AD

Monetary Policy• Higher or lower interest rates• Change in supply of money• Change in a country’s exchange rate

Fiscal Policy• Changes in direct / indirect taxes• Changes in government spending• Changes in government borrowing

Business and Consumer confidence• Planned investment spending• Consumer confidence and retail spending

UK Government Spending and Taxation

The Coalition Government has introduced a period of fiscal austerity – including deep cuts in government spending

Some Causes of Changes in AD

Monetary Policy• Higher or lower interest rates• Change in supply of money• Change in a country’s exchange rate

Fiscal Policy• Changes in direct / indirect taxes• Changes in government spending• Changes in government borrowing

Business and Consumer confidence• Planned investment spending• Consumer confidence and retail spending

Business Confidence Affects Investment

Capital spending collapsed during the recession and has struggled to recover since

Consumer sentiment is important for ADA change in sentiment is also a change in “animal spirits”

Changes in unemployment directly affect ADThe unemployment rate is measured as a percentage of the labour force

Changes in savings drive household spending

Disposable income can be spent or saved. A rise in savings brings about a contraction in consumption

External Factors and Aggregate Demand

Aggregate demand is also affected by macroeconomic events and policies in other countries - these might have a direct effect on the value of exports and imports, or the rate of inflation or the exchange rate

External Factors and Aggregate Demand

Aggregate demand is also affected by macroeconomic events and policies in other countries - these might have a direct effect on the value of exports and imports, or the rate of inflation or the exchange rate

EU economy US Economy Emerging Markets

European Union

The European Union is the UK’s biggest trade partner accounting for over 55% of total exports and imports

The economic cycle for the USA

How might stronger economic growth in the USA economy affect AD in the UK?

China Economy

GDP growth in the Chinese economy is slowing down – consider what this might mean for the UK

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