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Y1/IB 19) Consumer Spending and Aggregate Demand

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Aggregate Supply

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Aggregate demand (AD) is the total demand for goods and services produced within the economy over a period of time.

Aggregate demand (AD) is composed of various components.
AD = C+I+G+ (X-M)

C = Consumer expenditure on goods and services.

I = Gross capital investment - i.e. investment spending on capital goods e.g. factories and machines

G = Government spending e.g. spending on NHS, education. Note transfer payments in the form of pensions and unemployment benefits are not included because they are not related to output produced.

X = Exports of goods and services. Goods leave the country but money from abroad flows into the economy. Therefore this is an increase in AD (an injection into the circular flow)

M = Imports of goods and services, although goods enter the country money is leaving the economy to go to other countries. Therefore AD falls.

AD slopes downwards because

At a lower price level, people are able to consume more goods and services, because their real income is higher.

At a lower price level, interest rates usually, fall causing increased AD.

At a lower price level, exports are relatively more competitive than imports.

Shifts in the aggregate demand curve

Graph to show increase in AD

An increase in AD (shift to the right of the curve) could be caused by a variety of factors
1. Increased consumption:

An increase in consumers wealth (higher house prices or value of shares)

Lower Interest Rates which makes borrowing cheaper, therefore, people spend more on credit cards. Also, mortgage payments are cheaper which gives people more disposable income.

Higher wages

Lower Taxes

Increased consumer confidence about the future

Consumer expenditure accounts for about 66% of AD and therefore is a very important component of AD
2. Increased Investment

Lower interest rates, this makes borrowing for investment cheaper.

Increased confidence in the economic outlook

Improved technology

Increased economic growth, to meet increased demand firms need to increase capacity

3. Increased G

Government pursues expansionary fiscal policy

Government invests in infrastructure

4. Increased X

The UK more competitive, for example, an increase in labour productivity would make the UK more competitive

Increased growth in other countries, therefore they will have higher demand

Lower value of Sterling, this makes exports cheaper

5. Decreased M

The UK more competitive, this makes goods from other countries appear less competitive.

Lower value of Sterling, this makes imports more expensive

Lower GDP, therefore consumers will have less money to spend.

Fall in AD

In this diagram, we see a fall in AD. This causes a fall in real GDP and a fall in the price level (P1 to P2)

In this diagram, the fall in AD has mainly caused a fall in the price level, with little change in real GDP.

Components of AD

Components of aggregate demand as %

A graph showing components of AD as a %

In the above charts, I left out two minor factors NPISH and change in inventories to make it simpler.

Related

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Aggregate demand (AD) is the total demand for goods and services produced within the economy over a period of time. Aggregate demand (AD) is composed of various components. AD = C+I+G+ (X-M) C = Consumer expenditure on goods and services. I = Gross capital investment - i.e. investment spending on capital goods e.g.

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The equilibrium position of national income will change, ceteris paribus, following an economic shock. Economic shocks either arise from the demand side or the supply side.

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New government spending is an injection into an economy, and, like all injections, it will have a multiplier effect on national income.

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The international sector

The international sector includes exports (X), which add to to the value of aggregate demand, and are an injection into the circular flow of income, and imports (M), which reduce aggregate demand, and are a withdrawal from the circular flow. The more trade a country undertakes the 'open' it is said to be.

The UK is an important trading economy, with 50% of its trade being with the EU area, North American and Japan.

Exchange rates and equilibrium

Changes in exchange rates affect both imports and exports. A rise in the exchange rate will make exports more expensive and imports cheaper, and a fall in the exchange rate will reduce export prices, but increase import prices. Changes in exchange rates will encourage households and firms, at home and abroad, to alter their behaviour, as they would whenever price changes.

The Classical view is that if exports and imports become unbalanced, changes in the exchange rate will bring the international sector back into balance. For example, a temporary deficit, involving imports rising above exports, would lead to a fall in the value of the domestic currency. This is because the demand for the currency falls relative to the supply, reducing export prices, and raising imports prices. This should help to stimulate exports in the future and constrain imports, helping the economy to move back towards equilibrium.

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The international sector includes exports (X), which add to to the value of aggregate demand, and are an injection into the circular flow of income, and imports (M), which reduce aggregate demand, and are a withdrawal from the circular flow.

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Investment spending is an injection into the circular flow of income. Firms invest for two primary reasons

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Households dispose of their post-tax income by spending or saving. Saving is a withdrawal from the circular flow of income

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Household spending is the most important part of aggregate demand. It can be broken down into categories, covering major spending items like food, holidays, and clothing.

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Economists use a variety of models to explain how national income is determined, including the aggregate demand - aggregate supply (AD - AS) model.

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A video showing how aggregate demand and aggregate supply relate to the price level, and factors that can shift the aggregate demand and aggregate supply curves.

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Aggregate demand | Aggregate demand and aggregate supply | Macroeconomics | Khan Academy

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This lesson introduces the macroeconomic concept of Aggregate demand. AD is defined, and its components are explained individually, focusing on the factors that can lead to a change in the overall demand for a nation's goods and services in a particular period of time at a range of price levels.

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what influences the level of consumption in an economy?

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63 Aggregate Demand - consolidation exercise (1)

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62 Aggregate Demand - shifts in the AD curve (1)

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61 Aggregate Demand - exports and imports (1)

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60 Aggregate Demand - government spending (1)

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57 Aggregate Demand - an introduction (1)