Aggregate Demand

C + I + G + (X – M)

Lesson Objectives

To begin to understand the factors influencing the components of Aggregate Demand

To begin to understand the relative importance of these components

C + I + G + (X – M)

Aggregate Demand 

AD is the total demand for goods and services produced within the economy over a period of time. AD is the sum of planned expenditure for goods and services.

C + I + G + (X – M)

Circular flow of income, expenditure and output

If aggregate demand was in this model, it would comprise the combined spending of households and firms.

In the real world, also includes international trade and government spending

C + I + G + (X – M)

C= Consumption Spending I = Investment Spending G = Government Spending (X-M) = difference between spending on imports and receipts from exports (Balance of Payments)

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.

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.

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.

X - M

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.

The Aggregate Demand Curve

If price levels rise, real income will fall, and therefore so will output. So ... Aggregate demand slopes downward

Price level

Real Output

The Price Level is the average level of prices in the economy (CPI most commonly used)

Real output = real expenditure + real income

What do you think will happen to output – and demand – if the price level moves from P1 to P2?

Why does the AD curve slope downwards? (1)

Falling real incomes: As the price level rises, so the real value of people’s incomes fall and consumers are then less able to afford UK produced goods and services.

Why does the AD curve slope downwards? (2)

The balance of trade: As the price level rises, foreign goods and services become more attractive, causing a fall in exports and a rise in imports. This leads to a reduction in trade (X – M) and a contraction in aggregate demand.

Why does the AD curve slope downwards? (3)

Interest rate effect: if in the UK the price level rises, this causes an increase in the demand for money and thus a rise in interest rates with a deflationary effect on the entire economy. (This assumes that the Bank of England is setting interest rates in order to meet a specified inflation target.)

Shifts in the AD curve A change in factors affecting any one or

more components of aggregate demand; that is, households (C), firms (I), the government (G) or overseas consumers and business (X); changes planned aggregate demand and results in a shift in the AD curve.

ActivitiesRead pages 82-83Copy down all definitionsComplete activity on page 84Read the section on ‘Consumer

Expenditure’ (pp.84/85): copy down all definitions

Working in pairs, decide how the current government could encourage more consumer expenditure in order to boost the economy. What might be the advantages – and disadvantages – of your preferred method(s)?

Homework

1. Read and make notes on pages 85 to 88 (Saving and Investment)

2. Find, copy and comment on three articles about the UK economy in 2013. (For example, about growth or unemployment or trade.) We will use these to start next week’s lesson.