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Aggregate Demand Is Total Planned Spending, C Plus I Plus G Plus Net Exports

Definition

Aggregate demand: the total planned spending on an economy's domestic goods and services at a given price level, equal to consumption plus investment plus government spending plus net exports (C plus I plus G plus (X minus M)).

  1. Aggregate demand is total planned spending on domestic goods and services at a given price level.
  2. Its components are consumption, investment, government spending and net exports.
  3. In shorthand, AD=C+I+G+(X−M)AD=C+I+G+(X-M)AD=C+I+G+(X−M), where X is exports and M is imports.
Note
  • Consumption is normally the largest component, at roughly three-fifths of AD.
  • Net exports can be positive or negative.

Shape of the AD curve (downward sloping)

Consumption Is Usually the Largest of the Four Components

  1. Consumption is household spending, usually around three-fifths of AD.
  2. Investment is firms' spending on capital, and government spending is state spending on goods and services.
  3. Net exports are exports minus imports.
Example
  • UK household spending is the biggest single part of AD.
  • If imports exceed exports, net exports subtract from AD.

A Change in Any Component Moves Total Demand

  1. AD measures spending across the whole economy, not one market.
  2. A change in any component changes total demand.
  3. So the identity is the base for AD-AS analysis.

Causes of a shift in the AD curve

Causes of a shift in the AD curve

Always State the Full AD Identity

Exam technique
  • Write AD as C+I+G+(X−M)C+I+G+(X-M)C+I+G+(X−M).
  • Note that consumption is normally the largest component.
Common Mistake
  • Do not confuse aggregate demand with the demand for a single good.
  • And do not omit net exports from the identity.

Consumption and Saving Are Two Sides of Disposable Income

  1. Consumption is household spending out of disposable income.
  2. Saving is the part of disposable income not spent.
  3. So consumption and saving are inversely linked out of a given income.
Note
  • What is not spent out of disposable income is saved.
  • The savings ratio is the share of disposable income saved.

Income, Interest Rates, Confidence, Wealth and Credit Drive Consumption

  1. Higher disposable income raises consumption.
  2. Interest rates, confidence and wealth all shift spending.
  3. Easier credit lets households spend more of any income.
Example
  • Rising house prices can lift spending through a wealth effect.
  • Higher interest rates tend to raise saving and cut consumption.

Saving and Investment Are Different Acts by Different Agents

  1. Saving is income households choose not to spend.
  2. Investment is firms' spending on capital goods.
  3. So one is a withdrawal and the other an injection.

Link Consumption to Its Drivers

Exam technique
  • Name the determinants: income, interest rates, confidence, wealth and credit.
  • Explain saving as the mirror image of consumption.
Common Mistake
  • Do not confuse saving with investment.
  • Saving is a withdrawal; investment is an injection of spending on capital.

Investment Is Firms' Spending on Capital Goods

  1. Investment is spending by firms on capital goods.
  2. Gross investment is total spending on capital.
  3. Net investment is gross investment minus depreciation.
Note
  • Gross investment includes replacing worn-out capital.
  • Net investment is what adds to the capital stock.

Confidence, Interest Rates, Credit and Taxes Drive Investment

  1. The rate of economic growth and business confidence shape expected returns.
  2. Interest rates and the cost of borrowing affect the price of finance.
  3. The availability of credit and taxes on profits also matter.
Example
  • Keynes called swings in confidence the animal spirits of firms.
  • Lower interest rates make borrowing to invest cheaper.

Investment Is the Most Volatile Component of AD

  1. Investment depends on expectations about the future.
  2. Expectations can change quickly and sharply.
  3. So investment is the most volatile part of aggregate demand.

Separate Gross From Net Investment

Exam technique
  • Distinguish gross from net investment before analysing.
  • Link volatility to shifting expectations and confidence.
Common Mistake
  • Do not treat buying shares or saving in a bank as investment.
  • In economics, investment means firms' spending on capital goods.

Government Spending and Net Exports Complete Aggregate Demand

  1. Government spending and net exports are two components of aggregate demand.
  2. Government spending responds to the trade cycle, fiscal choices and political priorities.
  3. Net exports respond to incomes, the exchange rate and competitiveness.
Note
  • A change in either component shifts aggregate demand.
  • Net exports are exports minus imports.

The Trade Cycle, Exchange Rate and World Incomes Move G and Net Exports

  1. In a downturn, spending on benefits rises automatically.
  2. Real incomes at home and abroad change import and export demand.
  3. The exchange rate, protectionism and non-price competitiveness shift net exports.
Example
  • A weaker pound tends to raise exports and cut imports.
  • A strong world economy raises demand for UK exports.

Imports Are a Leakage, so They Are Subtracted From AD

  1. Exports add to aggregate demand.
  2. Imports are spending that leaks abroad, so they are subtracted.
  3. So a rise in imports lowers aggregate demand, all else equal.

Trace Each Influence to a Shift in AD

Exam technique
  • Link each influence to a shift in aggregate demand.
  • Remember that a rise in imports reduces net exports.
Common Mistake
  • Do not forget that imports are subtracted in aggregate demand.
  • A rise in imports lowers AD, all else equal.

The Accelerator Links Investment to the Rate of Change of Output

  1. The accelerator links net investment to the rate of change of output.
  2. Firms invest more when demand is growing faster.
  3. So even a slowdown in growth can cut investment.
Note
  • Net investment depends on the rate of change of national income.
  • A fall in the growth of demand can cause investment to fall.

Faster Output Growth Needs More Capital, so Investment Rises

  1. Rising output needs more capital, so investment rises.
  2. If output grows more slowly, less new capital is needed.
  3. So investment can fall even while output still rises.
Example
  • Worked example: suppose firms need £2 of capital for every £1 of annual output, a capital-output ratio of 2.
  • If output rises by £100 million this year, firms need 2×£100m=£200m2\times\pounds 100\text{m}=\pounds 200\text{m}2×£100m=£200m of extra capital, so net investment is £200 million.
  • If next year output rises by only £40 million, net investment falls to 2×£40m=£80m2\times\pounds 40\text{m}=\pounds 80\text{m}2×£40m=£80m, a sharp drop even though output is still growing.
  • The accelerator and multiplier can interact to amplify the cycle.

The Accelerator and Multiplier Interact to Amplify the Cycle

  1. The multiplier turns injections into larger income changes.
  2. The accelerator turns output changes into investment changes.
  3. Together they can magnify booms and slumps.

Focus on the Rate of Change, Not the Level

Exam technique
  • Tie investment to the rate of change of output, not its level.
  • Explain how the accelerator and multiplier interact.
Common Mistake
  • Do not confuse the accelerator with the multiplier.
  • The accelerator links investment to the rate of change of output; the multiplier links injections to a larger change in income.
Self review
  • Define aggregate demand and state the identity AD=C+I+G+(X−M)AD=C+I+G+(X-M)AD=C+I+G+(X−M).
  • Name the main determinants of consumption, investment, government spending and net exports.
  • How does saving differ from investment, and what determines the level of saving?
  • Using a capital-output ratio of 2, what is net investment if output rises by £50 million?
  • What does the accelerator link, and why does it depend on the rate of change of output?
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2.2.3 The determinants of aggregate demand Revision Guide

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