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Aggregate Demand
EdExcel AS Economics 2.2.1
Meaning and Measurement of Aggregate Demand
• Aggregate Demand (AD) =– Total level of planned real expenditure on the goods and
services produced within a country• The components of aggregate demand are:
– Household spending on goods and services (C)– Gross Fixed Capital Investment Spending (I)– Value of the Change in Stocks (Inventories) – Government Consumption (G) (Public services)– Exports of Goods and Services (X)– (minus) Imports of Goods and Services (M)
• GDP (expenditure-based) is the actual value of expenditure• Changes in AD are key to understanding short-term fluctuations
in a cycle e.g. recession and recovery, boom and slowdown
Components of UK Aggregate Demand 2007-2015
Source: HM-Treasury Databank
Consumption (C)
Government Spending (G)
Investment (I)
Exports (X)
Imports (M)
Year Per cent Per cent Per cent Per cent Per cent
2007 2.8 1.2 5.3 -2.1 -0.8
2008 -0.5 2.0 -4.7 1.6 -1.8
2009 -3.3 1.2 -14.4 -8.2 -9.8
2010 0.5 0.0 5.9 6.2 8.7
2011 -0.1 0.0 2.3 5.6 1.0
2012 1.5 2.3 0.7 0.7 3.1
2013 1.7 -0.3 3.4 1.5 1.4
2014 2.6 1.6 8.6 0.5 2.4
2015
The Relative Importance of Components of AD
Source: HM-Treasury Databank
Consumption (C)
Government Spending (G)
Investment (I)
Exports (X)
Imports (M)
Year £m £m £m £m £m
2007 1021 326 294 477 538
2008 1016 333 281 485 528
2009 982 337 240 445 476
2010 987 337 254 472 518
2011 985 337 260 499 523
2012 1000 345 262 502 539
2013 1018 344 271 510 547
2014 1044 349 294 512 560
2015
Consumption is far and away the biggest component of AD
The Aggregate Demand Curve (AD)
General Price Level
Real GDP
AD = C+I+G+(X-M)
GPL1
Y1Y2
GPL2
GPL3
Y3
A rise in the price level causes a contraction of AD
The Aggregate Demand Curve (AD)
General Price Level
Real GDP
AD = C+I+G+(X-M)
GPL1
Y1Y2
GPL2
GPL3
Y3
A rise in the price level causes a contraction of AD
A fall in the price level causes an expansion of AD
Understanding why the AD Curve Slopes Downwards
Falling real incomes
• As the price level rises, the real value of income falls and consumers are less able to buy what they want or need – this is known as the real balance effect
Balance of trade
• A persistent rise in the price of level of Country X could make foreign-produced goods and services cheaper, causing a fall in exports and a rise in imports
Interest rate effect
• If the price level rises, this causes inflation and an increase in demand for money and a possible rise in interest rates on loans which then has a deflationary effect on consumer and business demand
Shifts in the Aggregate Demand Curve (AD)
General Price Level
Real GDP
AD1
GPL1
Y1
AD2
Y2
AD3
AD1 – AD2: Outward shift – will raise national output at all price levels
Shifts in the Aggregate Demand Curve (AD)
General Price Level
Real GDP
AD1
GPL1
Y1
AD2
Y2
AD3
Y3
AD1 – AD2: Outward shift – will raise national output at all price levels
AD1 – AD3: Inward shift – will reduce national output at all price levels
Examples of Causes of Shifts in Aggregate Demand
Fall in AD
Fall in exports
Cut in government spending
Higher interest rates
Decline in household wealth
Increase in AD
Depreciation of the exchange rate
Cuts in direct and indirect taxes
Increase in house prices
Expansion of supply of credit + lower interest rates
Changes to Monetary Policy• Changes in official monetary policy interest rates• Change in the supply of money and credit• Change in the value of a country’s exchange rate
Changes to Government Fiscal Policy• Changes in the level of direct / indirect taxes• Changes in government (state) spending• Changes in government (fiscal) borrowing
Business and Consumer confidence• Planned capital investment spending by
businesses• Consumer confidence and retail spending
Focus on Key Causes of Shifts in Aggregate Demand
External Shocks to Aggregate Demand
Many unexpected events cause changes in demand, output and employment. These events are called external “shocks”.
A large rise or fall in the value of the exchange rate
A recession, slowdown or boom in one or more of a nation’s key trading partner countries
A slump in the housing market / construction sector of a country
An event such as the Global Financial Crisis which caused a fall in the supply of credit available to businesses and households
A large change in commodity prices for a country that is a commodity exporter
Exports of Goods and Services (X)
Relative Prices of exports in
World Markets
The exchange rate – a stronger currency
makes exports more
expensive
Non-Price Demand
Factors e.g. Design and Branding
Strength of Aggregate
Demand in Key Export
Markets
Exports are goods and services sold to other countries. Exports are an injection into a nation’s circular flow of income and spending
Many factors affect the level of demand for a nation’s exports – some of these are shown on the left
The Net Trade Balance (X-M) and Aggregate Demand
The net trade balance is measured the value of exported goods and services minus the value of imported products
A trade surplus means that X>M – aggregate demand will increase
A trade deficit means that M>X – aggregate demand will fall
If X=M, then the trade balance is zero, external trade will have a neutral effect on AD
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 20140
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Trad
e ba
lanc
e in
bill
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U.S
. dol
lars
Balance of Trade for China 2000-2014
• Public sector debt is owed by central and local government and by public (state-owned) corporations– Debts owed by state-owned banks are included in national debt
• Private sector debt is owed by private businesses and households. – Companies may have borrowed to finance investment
(corporate sector debt)– Households have loans for example credit card debt and
mortgages on properties.• Financial debt is also part of the private sector – this is
the outstanding (unpaid) debts of banks and financial corporations - for example the level of bad debts on loans to businesses and to the housing market
Public and Private Sector Debt
• In the spring of 2013, household and non-financial firms’ debt amounted to 208% of UK GDP – down to levels last seen in mid-2007, but significantly higher than they were a decade ago (170pc of GDP) and 15 years ago (128pc of GDP).
• The UK private debt/GDP ratio is high by historical and international standards, and far above the 160% level used by the EU Commission as a threshold for gauging imbalance in debt to income levels for EU member states.
The Scale of Debt in the UK Economy
UK Household Debt Relative to Disposable Incomes
19881988198819881989198919891989199019901990199019911991199119911992199219921992199319931993199319941994199419941995199519951995199619961996199619971997199719971998199819981998199919991999199920002000200020002001200120012001200220022002200220032003200320032004200420042004200520052005200520062006200620062007200720072007200820082008200820092009200920092010201020102010201120112011201120122012201220122013201320132013201460
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160Short-term Loans
Long-term Loans
Stock of outstanding loans to households, % of households’ disposable income
• Short term loans include outstanding debt on credit cards• Long term loans include mortgage debt
• Debt acts as a constraint on future spending power. – Millions of people in the UK are saddled with many thousands
of pounds of debt and the interest payments on this debt reduces their effective disposable income
• The commercial banks also have high debt and this restricts their ability to make fresh loans to businesses and households who want to borrow. This can limit business investment
• The economy can be at risk with a high debt-to-GDP ratio– If price deflation happened, falling consumer prices and
incomes would make the debt problem even worse in real terms
– When nominal interest rates rise, many households – especially mortgage payers - are at risk and can struggle to meet repayments. This could cause a slowdown or a possible recession in the housing market.
Consequences of Debt for an economy such as the UK
Aggregate Demand
EdExcel AS Economics 2.2.1
