MACRO – Aggregate Demand (AD)

key macroeconomic concept Aggregate Demand The total demand (expenditure) for an economy’s goods and services at a given price level, over a period of time. AD=C+I+G+(X-M)

The Components of Aggregate Demand C Consumption / Consumer Expenditure I Investment / Investment Expenditure G Government Expenditure X-M Net Exports = Export revenue – Import expenditure Aggregate Demand (AD) = C + I + G + (X-M) The four components of Aggregate Demand are:

The Aggregate Demand Curve AD1 There is an inverse relationship between AD and the general price level 3 reasons why… General Price Level Real GDP Y1Y2 PL1 PL2

The AD Curve – The Inverse Relationship A rise in the price level reduces the real value of income and wealth and decreases households’ ability to consume. Sometimes called ‘the wealth effect’ A higher price level increases households’ and firms’ demand to hold money for transaction purposes. The increase in demand for money is likely to raise the interest rate and thereby reduce consumption and investment (if interest rates are higher it costs more to borrow money so households and firms borrow less and therefore spend less). Sometimes called ‘the interest rate effect’ A higher domestic general price level leads to domestically produced goods and services being less price competitive. Consumers and firms are likely to buy more from foreign sources and less from domestic producers. Sometimes called ‘the international trade effect’.

The AD Curve – The Inverse Relationship 1.The Wealth Effect A lower general price level will result in a greater amount of goods and services that wealth (assets) can buy & vice versa 2.The Rate of Interest Effect A higher general price level may require some financial assets to be sold to pay for the higher prices (government bonds are a financial asset). As bonds are sold the price of the bonds may fall, leading to a likely increase in the rate of interest. At higher rates of interest, consumption and investment are likely to be lower. 3.The International Trade Effect A higher domestic general price level, assuming no change in the price levels in the foreign sector and exchange rates, leads to domestically produced goods and services being less price competitive. Consumers and firms are likely to buy more from foreign sources and less from domestic producers. Net exports are more favourable at lower price levels than at higher price levels.

Shifts in the AD curve AD1 A change in any factor that influences aggregate demand, through the effect on the components of AD, will cause a shift in the AD curve. A shift in the curve indicates AD has changed at each and every price level (an increase is shown here). General Price Level Real GDP AD 2 Y1Y2 PL1

Consumption / Consumer Expenditure C Consumption is usually the largest component of AD. It is the total spending by consumers, or households, on consumer goods and services in a given period of time. What would cause a rise or a fall in Consumption expenditure? Changes in: Real disposable income (influenced by changes in direct taxation) Wealth (influenced by changes in asset prices) Consumer confidence and expectations The rate of interest In addition, the nature of the consumption is affected The age structure of the population Distribution of income

More on consumption A rise in income will lead to a rise in consumption This can be measured by the marginal propensity to consume (MPC) MPC= ΔC/ ΔY Likely to be more than 0, but less than 1 (more than 1 would indicate money was borrowed to finance spending higher than income) The average propensity (APC) to consume measures the average amount spent on consumption out of total income APC= C/ Y In most developed countries the APC is less than 1 as most households save part of their income. APC usually falls as income rises

Investment / Investment Expenditure I Investment is usually the most volatile component of AD. It is the total spending by firms on capital goods in a given period of time. Influences on the levels of Investment; Changes in: The rate of interest Corporation tax Changes in real disposable income (link to accelerator theory) Expectations including anticipated rate of return Advances in technology

Government Expenditure G The influence of government spending on AD differs between countries. It is the total spending by government on goods and services in a given period of time. Influences on the levels of government expenditure; The government’s view of how much intervention is needed to correct for market failure. Previous spending commitments by government The amount of taxation revenue being raised The level of economic activity The level of borrowing the government is prepared to undertake Political motives Policy decisions to influence macroeconomic performance

Net Exports X-M Exports are a country’s goods and services that are sold abroad. Imports are goods and services that are bought from abroad. Net exports = The total value of exports – total value of imports, in a given period of time. Influences on the levels of net exports; Real disposable income at home. Real disposable income abroad. The domestic price level. The relative inflation rates. The exchange rate. Relative price levels Trade policy decisions

Quick Quiz 6 th April 1.4 macroeconomic obj of gov? (4 marks) 2.Definition of AD (2 mark) 3.Withdrawals from the circular flow? (3 marks) 4.Injections to the circular flow? (3 marks)

Task Increase or Decrease AD? For each point below explain which component is likely to be affected and consequently whether this is likely to increase or decrease AD A. A fall in house prices B. A rise in consumer confidence C. A decrease in interest rates

Increases in AD AD1 Possible causes of an increase in aggregate demand, shown by a shift of the AD curve to the right (AD 1  AD 2 ) Increasing consumer confidence Increased government expenditure Reduced taxation Increasing business optimism A cut in interest rates An increase in the money supply A fall in the relative value of the domestic currency An increase in the size of the population An increase in wealth (increasing value of financial and fixed assets) General Price Level Real GDP AD2 It is very important to be able to explain why this would occur, through the effect on the components of AD

Reductions in AD AD2 Possible causes of a decrease in aggregate demand, shown by a shift in the AD curve to the left (AD  AD 1 ) Declining consumer confidence Reduced government expenditure Increased taxation Increasing business pessimism An increase in interest rates A reduction in the money supply An increase in the relative value of the domestic currency A reduction in the size of the population A fall in wealth (decreasing value of financial and fixed assets) General Price Level Real GDP AD1 Again, It is very important to be able to explain why this would occur, through the effect on the components of AD

Task Complete handout P179 Student workpoint 14.6 Homework Read page and using your textbook and notes (this is not a test) answer the following- on 1 side of A4 Distinguish between GDP, GNP, NNP (10 marks)

Additional concept The Multiplier effect The process by which any change in an injection (G, I, X) results in a greater final change in GDP. For example, an increase in government spending will increase GDP, as G is a component of AD. The injection will be multiplied through the economy as consumers receive a share of the income and then spend a proportion of what they receive. The size of the final increase will be determined by the size of the multiplier effect. The Marginal Propensity to Consume (MPC) will influence the size of the multiplier effect, as it indicates what proportion of the additional income is spent.

Additional concept The Multiplier effect The Multiplier = 1 or 1 1- mpc mps+mpt+mpm For example, there is an increase in government spending of £100m. If £30m is taken in tax, £10m is spent on imports and £5m is saved, £55m is spent (mpc = 0.55). The final addition to national income: £100m x 2.2 = £222m. The addition to income would be greater if the marginal propensity to consume is higher. This occurs when the leakages take less of the additional income.