Aggregate Demand (AD)

Aggregate demand: The total demand for a country’s goods and services.

Aggregate demand has many components. If any of these components increase, AD will shift to the right (AD → AD1). The term “aggregate” refers to the whole economy.

Components of AD

• Consumption (C)
• Investment (I)
• Government spending (G)
• Net exports (X − M)

Consumption

Disposable income

More income → more purchasing power → higher consumption → AD → AD1 (rightward shift ie increases)

Interest rates

Higher interest rates → higher cost of borrowing + higher reward for saving → consumers save more and spend less → consumption falls → AD → AD1 (leftward shift i.e. decreases)

Income tax

Lower income tax → higher disposable income → higher consumption → AD → AD1 (right ward shift)

Consumer confidence (state of the economy)

Weak economy/recession (e.g. COVID-19) → lower confidence + more uncertainty → households save more and spend less → consumption falls → AD → AD1 (leftward shift)

Price level

Higher prices → lower real purchasing power → consumption falls (in real terms)

Investment (I) (also affects LRAS)

Interest rates

Higher interest rates → higher cost of borrowing → firms invest less → investment falls → AD → AD1 (left)

Cost of raw materials / production costs

Higher costs → lower profits → firms cut back investment → investment falls → AD → AD1 (left)

Business confidence

Strong economy / high profits → higher confidence → firms invest more → AD → AD1

Corporation tax

Higher corporation tax → lower after-tax profits → less internal finance → investment falls → AD → AD1 (left)

Consumption (link effect)

Higher consumption → higher sales and profits → firms expand and invest more → AD → AD1

Examples of Investment Effects

Research & Development (R&D): R&D ↑ → innovation ↑ → product quality and choice↑ → international competitiveness ↑ → exports ↑ → AD ↑

Training & technology: Training + tech ↑ → productivity ↑ → efficiency ↑ → lower costs → lower prices → consumers better off + firms more competitive → exports ↑ → AD ↑ → higher growth and improve current account

Hiring more workers: expand production → Hiring ↑ → employment ↑ → incomes ↑ & tax revenue ↑

Net Exports (X − M)

Net exports = Exports − Imports

Exports are goods and services sold to other countries.
Imports are goods and services bought from other countries.

If exports rise or imports fall → net exports increase → AD → AD1

Factors which increase net exports:

Quality of domestic goods: Higher quality domestic goods → more internationally competitive products → exports increase → AD → AD1

Lower domestic prices: Lower prices → UK goods become more attractive abroad → foreign demand increases → exports increase → AD → AD1

Exchange rate: Depreciation of currency → weaker pound → UK goods become cheaper for foreigners → exports increase + imports decrease → net exports increase → AD → AD1

Example:
£1 used to buy $1.50 → now buys $1.30 → pound has depreciated → UK exports become cheaper → demand for UK goods rises → AD increases

Tariffs

Tariffs = tax on imports which make imports more expensive.

Higher tariffs → imports become more expensive → imports fall → net exports increase → AD → AD1

Government Spending (G)

Government spending refers to total spending by the government on goods and services such as healthcare, education, defence, and infrastructure.

An increase in government spending → AD → AD1
A decrease in government spending → AD → AD1 (left)

Economic crisis (COVID, wars, recession)

Economic crisis → higher need for public support (e.g. healthcare, furlough schemes, defence spending) → government spending increases → AD → AD1

Tax revenues

Higher tax revenues → government has more funds available → increased ability to spend on public services and investment → government spending increases → AD → AD1
Lower tax revenues → reduced government budget → potential cuts in spending → AD → AD1 (left)

Demographic changes

Ageing population → higher demand for pensions, healthcare, and social care → government spending increases → AD → AD1

Trade cycle (business cycle)

Recession → government often increases spending to stimulate demand → AD → AD1
Boom → government may reduce spending or aim to control inflation → AD → AD1 (left or slower growth)

KEY CHAIN OF ANALYSIS TAKEAWAY

• HIGHER CONSUMPTION –> HIGHER INVESTMENT --> HIGHER EXPORTS

LINK TO MULTIPLIER EFFECT TOO AS MANY SHIFTS IN AD!