Aggregate Demand This section gives you a platform for understanding issues such as inflation, economic growth andunemployment.

Aggregate demand (AD) and aggregate supply (AS) analysis provides a way of illustrating macroeconomic relationships and the effects of government policy changes. Aggregate Demand The identity for calculating aggregate demand (AD) is as follows: AD = C + I + G + (X-M) Where 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. Capital investment spending in the UK typically accounts for between 15-20% of GDP in any given year. Of this investment, 75% comes from private sector businesses such as Tesco, British Airways and British Petroleum and the remainder is spent by the public (government) sector for example investment by the government in building new schools or investment in improving the railway or road networks. So a mobile phone company such as O2 spending 100 million on extending its network capacity and the government allocating 15 million of funds to build a new hospital are both counted as part of capital investment. Investment has important long-term effects on the s supply-side of the economy as well as being an important although volatile component of aggregate demand. 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. We will return to this again when we look at how the government runs its fiscal policy. Transfer payments in the form of welfare benefits (e.g. state pensions and the job-seekers allowance) arenot included in general government spending because they are not a payment to a factor of production for any output produced. They are simply a transfer from one group within the economy (i.e. people in work paying income taxes) to another group (i.e. pensioners drawing their state pension having retired from the labour force, or families on low incomes). The next two components of aggregate demand relate to international trade in goods and services between the UK economy and the rest of the world. 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.

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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 atrade deficit (reducing AD). The UK economy has been running a large trade deficit for several years now as has the United States. Aggregate demand shocks

Economic events such as changes in interest rates and economic growth in the United States can have a powerful effect on other countries including the UK. This is because the USA is the worlds largest economy. 15 per cent of our exports go to the USA.

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A capital investment boom e.g. a construction boom to increase the supply of new houses or to build new commercial and industrial buildings. A rise or fall in the exchange rate affecting net export demand and having follow-on effects on output, employment, incomes and profits of businesses linked to export industries. A consumer boom abroad in the country of one of our major trading partners which affects the demand for our exports of goods and services. A large boom in the housing market or a slump in share prices. An unexpected cut or an unexpected rise in interest rates.

Lots of unexpected events can happen which cause changes in the level of demand, output and employment in the economy. These unplanned events are called shocks One of the causes of fluctuations in the level of economic activity is the presence of demand-side shocks. Some of the main causes of demand-side shocks are as follows:

The Aggregate Demand Curve The AD curve shows the relationship between the general price level and real GDP.

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Why does the AD curve slope downwards?

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Falling real incomes: As the price level rises, so the real value of peoples incomes fall and consumers are then less able to afford UK produced goods and services. The balance of trade: As the price level rises, foreign-produced goods and services become more attractive (cheaper) in price terms, causing a fall in exports and a rise in imports. This will lead to a reduction in trade (X-M) and a contraction in aggregate demand. Interest rate effect: if in the UK the price level rises, this causes an increase in the demand for money and a consequential rise in interest rates with a deflationary effect on the entire economy. This assumes that the central bank (in our case the Bank of England) is setting interest rates in order to meet a specified inflation target.

There are several explanations for an inverse relationship between aggregate demand and the price level in an economy. These are summarised below:

Shifts in the AD curve A change in factors affecting any one or more components of aggregate demand, 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. Consider the diagram below which shows an inward shift of AD from AD1 to AD3 and an outward shift of AD from AD1 to AD2. The increase in AD might have been caused for example by a fall in interest rates

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or an increase in consumers wealth because of rising house prices.

Factors causing a shift in AD Changes in Expectations Current spending is affected by anticipated future income, profit, and inflation

The expectations of consumers and businesses can have a powerful effect on planned spending in the economy E.g. expected increases in consumer incomes, wealth or company profits encourage households and firms to spend more boosting AD. Similarly, higher expected inflation encourages spending now before price increases come into effect - a short term boost to AD. When confidence turns lower, we expect to see an increase in saving and some companies deciding to postpone capital investment projects because of worries over a lack of demand and a fall in the expected rate of profit on investments. An expansionary monetary policy will cause an outward shift Changes in Monetary of the AD curve. If interest rates fall this lowers the cost of Policy i.e. a change in borrowing and the incentive to save, thereby encouraging interest rates (Note there is more than one consumption. Lower interest rates encourage firms to borrow interest rate in the economy, and invest. although borrowing and There are time lags between changes in interest rates and the savings rates tend to move in changes on the components of aggregate demand. the same direction) For example, the Government may increase its expenditure e.g. Changes in Fiscal Policy

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Fiscal Policy refers to changes in government spending, welfare benefits and taxation, and the amount that the government borrows

financed by a higher budget deficit, - this directly increases AD Income tax affects disposable income e.g. lower rates of income tax raise disposable income and should boost consumption. An increase in transfer payments raises AD particularly if welfare recipients spend a high % of the benefits they receive.

A fall in the value of the pound () (a depreciation) makes Economic events in the imports dearer and exports cheaper thereby discouraging international economy International factors such as imports and encouraging exports the net result should be that the exchange rate and foreign UK AD rises the impact depends on the price elasticity of income (e.g. the economic demand for imports and exports and also the elasticity of cycle in other countries) supply of UK exporters in response to an exchange rate depreciation. An increase in overseas incomes raises demand for exports and therefore UK AD rises. In contrast a recession in a major export market will lead to a fall in UK exports and an inward shift of aggregate demand. The UK is an open economy, meaning that a large and rising share of our national output is linked to exports of goods and services or is open to competition from imports. A rise in house prices or the value of shares increases Changes in household consumers wealth and allow an increase in borrowing to wealth Wealth refers to the value of finance consumption increasing AD. In contrast, a fall in the assets owned by consumers value of share prices will lead to a decline in household e.g. houses and shares financial wealth and a fall in consumer demand.

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