ECON2: The National Economy

2.5 The Determinants of Aggregate Demand

What is meant by the term aggregate?

What is macroeconomics the study of?

2.5 What you need to knowThe concept of aggregate demandThe determinants of aggregate demandThe determinants of savingThe difference between saving and

investmentThe concept of the accelerator

2.5 You should be able to:Define aggregate demandExplain and analyse the determinants of

aggregate demandIllustrate the effects of changes in aggregate

demand on a diagramExplain and analyse the determinants of saving

in an economyExplain the difference between saving and

investmentBriefly explain the role of accelerator in an

economy

Aggregate Demand: A Definition

Recap. What is the shape of a normal demand curve? Why is it downward sloping? What does ‘aggregate’ mean?

“The total demand for all goods and services in an economy at any given price level over a period of time”.

Class estimate: What do you think is the total value of demand for goods and services

in the UK?

The Aggregate Demand Curve

Price Level

Real National Output

AD

P

Y

Building diagrams: Axis? AD Curve? Labels?

The price level is the average of prices for all goods and services in an economy.

Real national output is the output of the economy taking into account inflation.

We can use the formula:

Nominal (Money) National Output Average Price Level

The Components of Aggregate Demand

Aggregate Demand (AD) has 4 main components

It is crucial to know and understand these in order to analyse AD more closely

1. Consumption (C)2. Investment (I)3. Government Spending (G)4. Net Exports (Exports – Imports) (X-M)

The AD Formula

AD comprises the sum of each of these 4 components:

C + I + G + (X-M)

The Composition of AD

Which of the 4 components of AD do you think contributes the most to the UK economy? Which

contributes the least?

63%15%

25%

3%

Components of AD in the UK 2012

Source: ONS

• Consumption

• Investment

• Government Spending

• Net Exports

Consumption (1)

Income Higher levels of disposable income will normally lead to

greater levels of consumption as individuals can afford more goods and services

Disposable income will change depending upon, for example, tax or wage rates

Interest rates Lower interest rates will normally increase consumption as

saving becomes less attractive, loans become more affordable and individuals with variable rate mortgages see monthly disposable income increase

Levels of personal debt If individuals have low levels of personal debt e.g. credit

cards or loans they will normally consume more as less disposable income is diverted to repayments

What determines the level of consumption in a household?

Consumption (2)

Levels of personal wealth Individuals with higher levels will tend to consume

more as they can borrow funds against the value of assets e.g. their house

Confidence If individuals have confidence in their short, medium

and long term economic prospects, it is likely that they will increase their spending

This is often linked to their employment prospects or job security

Marginal propensity to consume/save This refers to how likely an individual is to consume or

save an extra £1 of income they receive It is usually dictated by a combination of the above

factors

MPC/MPS

If I gave you £100 today what would you do with it?

What is your marginal propensity to consume?

What is your marginal propensity to save?What factors influence your MPC and MPS?

Consumption is the largest, and thus the most important, element of AD. It is a major driver of the economy.

The Pattern of UK Consumption

Food

& drin

k

Alcoho

l & to

bacc

o

Clothin

g & fo

otwea

r

Housin

g

House

hold

item

s

Health

Trans

port

Comm

unica

tion

Recre

ation

& c

ultur

e

Educa

tion

Resta

uran

ts &

hot

els

Misc

ellan

eous

0

50000

100000

150000

200000

250000

£b

n

Source: ONS

Saving Whilst not a component of aggregate demand, the level of saving in an economy has a direct impact upon the level of consumption, and hence, aggregate demand

In economics, any disposable household income that is not used for consumption is said to have been saved

Why are women saving less than men?

Determinants of Saving

Interest rates Higher interest rates increase the incentives to save as the reward is greater

Confidence If individuals and workers are nervous about the future, they may be inclined to save more of their income in the event of wage cuts, wage freezes or redundancy

Inflation If prices are rising quickly, then the real value of savings is eroded, so the incentive to save reduces

Investment (1)

Spending by firms on capital goods

Important note – Investment is not to be confused with investment by an

individual in stocks, shares or bonds. In economics, investment is only

concerned by firms with the aim of improving capital in terms of quantity,

quality or efficiency.What determines the level of investment by

firms?

Investment (2) Interest rates

Lower interest rates make investment projects less costly and normally help to stimulate investment

Confidence If firms are confident in future economic prospects and

the likelihood of consumption increasing, they are more likely to invest in capital projects

Government incentives Businesses may be able to take advantage of

government grants to compliment their own investments This often applies to new business start-ups or

businesses locating in an area of social deprivation

Investment (3)

Economic growth The faster the pace of economic growth, the sooner

capital equipment will wear out or require replacement, so investment increases

Profit levels Higher profit levels will often be re-invested to maintain a

firm’s growth Price of capital equipment

If the price of capital equipment falls relative to the cost of labour, it may make investment projects more attractive

Technology The requirement to keep up to date or gain competitive

advantage through technological advances may drive new investments

The Pattern of UK Investment

Source: ONS

The Accelerator The accelerator effect shows the relationship between Gross Domestic Product (GDP) and the rate of investment

It states that a rise in GDP will lead to a proportionately larger increase in investment

Why might this happen? If a firm sees that GDP and AD is increasing, it needs to be certain that this is going to be sustained

Initially, the firm will use their existing capacity and make their existing capital and labour force work harder to meet this growing demand

At some point, the firm will reach full capacity, and if they believe that growth will be sustained, they will invest in capital equipment to meet future anticipated demand

This increase in investment will boost AD still further and assist yet more economic growth

Government Spending

Tax revenue and borrowing spent by the government for the benefit of the country’s citizens

The precise levels of government spending, and the areas of the economy that have money spent on them, will vary according to the government’s reading of economic conditions and the varying priorities of the government of the day

Why is the current government making spending cuts?

Net Exports (Exports – Imports)

We are only concerned with demand and output generated within a country, hence imports are deducted

What determines the level of Exports and Imports ? Write down as many variables as

you can.

Net Exports (Exports – Imports) UK productivity

If the UK is more productive and efficient in the production of goods and services, it is likely we will be more competitive in global export markets

Exchange rates A strengthening currency will make UK exports less competitive

Demand may fall A stronger currency will also make imports more attractive to UK

consumers and they may increase Net exports will therefore worsen

A weaker currency should have the opposite effect and improve net exports Economic growth in other countries

Strong economic growth in key export markets e.g. Europe, USA and China gives opportunities for UK firms to export goods and services to new markets

Extent of free trade As free trade broadens e.g. enlargement of the EU this gives rise to new

export opportunities

Shifts and Movements of the AD Curve

A change in the price level leads to a movement along the AD curve

Shifts in the AD curve will occur if there is a change in any of the components of AD (C, I, G, X or M)

Movements Along the AD Curve

Price Level

Real National Output

AD

P

Y

P2

P1

Y1 Y2

A rise in the price level leads to a contraction in aggregate demand.

A fall in the price level leads to an expansion in aggregate demand.

Shifts of the AD Curve

Price Level

Real National Output

AD

P

YY2 Y1

An increase in any of the components of AD will lead to a shift from AD to AD1.

AD2

AD1

A decrease in any of the components of AD will lead to a shift from AD to AD2.

Multiple Choice 1

In the short run, a decrease in aggregate demand is most likely to be caused by a growth ina) exportsb) importsc) consumptiond) investment

Can you explain your answer?

Multiple Choice 2

In economics, investment is best defined asa) the flow of money into the stock of savingsb)spending on capital goods in an economyc) the profit kept back by firms to finance future

expenditure on new machinery and equipmentd)the stock of economic resources such as

factories and machinery

Can you explain your answer?

Multiple Choice 3

Aggregate demand has increased in an economy. Which of the following combinations would be most likely to cause the increase?

Can you explain your answer?

Household Savings

Business Investment

A Rise Rises

B Rise Falls

C Fall Falls

D Fall Rises

Multiple Choice 4

Which of the following statements concerning UK investment is correct?a) Increased investment leads to a reduction in savingb) Investment is the largest component of aggregate

demandc) Investment is a withdrawal from the circular flow of

incomed) Investment can increase the capital stock of the

economy

Can you explain your answer?

2.5 You should be able to:

Define aggregate demandExplain and analyse the determinants of

aggregate demandIllustrate the effects of changes in aggregate

demand on a diagramExplain and analyse the determinants of saving

in an economyExplain the difference between saving and

investmentBriefly explain the role of accelerator in an

economy