Aggregate Demand

Aggregate Demand Definition

Aggregate demand is defined as follows:

What is the aggregate demand formula?

The four main sources of spending in aggregate demand originate from different sectors of the economy. These are households, firms, the government, and exports and imports. We represent these sectors in an equation known as the aggregate demand (AD) equation:

\(AD=C+I+G+(X-M)\)

What are the components of aggregate demand?

BasedThe components of aggregate demand are:

• C = Consumption (spending by households).
• I = Investment (spending by firms).
• G = Government spending (spending by the government).
• (X-M) = Exports minus imports (the difference between how much we sell and buy foreign goods and services).

Let’s look into the four components of aggregate demand in detail.

Consumption and saving in aggregate demand

Consumer spending is the single largest component of aggregate demand. It made up 60.8% of the nominal GDP (gross domestic product) in June 2021.

Whenever consumers decide whether or not to spend money on goods and services, they are at the same time deciding whether or not to save. Both consumption and saving are interrelated since a determinant of consumption is also a determinant of household saving.

Consumption consists of goods with different life spans:

• Non-durable goods are consumed in one use or over a short period, e.g. food, petrol, clothes.

• Durable goods have a long life span, e.g. automobiles, household appliances, furniture.

There are a variety of determinants that influence consumption and savings:

• Interest rates

• Availability of credit

• Level of real disposable income

• Distribution of income

• Availability of wealth

• Consumer confidence

Interest rates

There are various types of interest rates in the economic environment. These include:

• Interest rates on savings in the bank and other accounts.

• Borrowing interest rates.

• Mortgage interest rates (housing loans).

• Credit card interest rates and payday loans.

• Interest rates on government and corporate bonds.

The interest rate rewards savers for sacrificing their current consumption. The higher the interest rate, the greater the reward will be. Therefore, one could argue that a higher interest rate could lead to lower consumption as households could choose to save to get a higher reward.

Availability of credit

Interest rates are very closely interlinked with the availability of credit. If more credit becomes available and the interest rate is low (meaning that borrowing is cheap), it could encourage households to spend more by supplementing their income with loans from banks. For example, they may choose to get a mortgage, buy a car or go on vacation.

On the flip side, higher interest rates would increase the cost of borrowing, and more households would not be inclined to borrow money from the bank on credit. This could lead to a reduction in overall consumption.

Level of real disposable income

The level of income is perhaps the most important reason for choosing whether to spend or save. Income can be real and disposable. Real income refers to the income adjusted for changes in price levels. Disposable income is the income after all the fixed expenses have been deducted from the paycheck.

Distribution of income and wealth

Distribution of income refers to the wealth balance between the more and less affluent people in the economy, i.e. the so-called rich and poor divide. People with different incomes have different spending habits.

The government can also regulate the distribution of income by introducing an effective tax system. At the moment, the UK operates a progressive tax system. A progressive system imposes higher rates on higher-income earners as opposed to those on a lower income.

Such a system aims to control how burdensome would the tax be onto the earner and adjust as the income rises or falls. This is done to continue the inflow of money into the government budget, but also to try and equalize the impact on a person’s disposable income by making it proportional to the size of their earnings. The idea is that it is fairer for the bigger earners to carry a heavier tax burden. However, the more tax people need to pay, the less likely they will be to spend money on goods and services, which ultimately affects aggregate demand.

As we already mentioned, the amount of personal wealth a household possesses in addition to their flow of income influences the decisions they make on consumption and savings.

For property owners, rising house prices induces a ‘feel-good’ factor as it has the effect of increasing consumer spending sprees. However, as housing prices fall, they have the opposite effect of a ‘feel-bad’ factor as more consumers would take a more precautionary role and start saving more. Such a move would affect the consumer expenditure component in the AD leading to its likely decrease.

Consumer confidence

Consumer confidence is largely dependent on the households’ views on their expected income as well as the changes in their personal wealth. When household optimism rises, the amount of spending on goods and services increases and savings decrease. Conversely, when household optimism decreases, the amount of spending on goods and services will decrease and savings increase.

Personal savings ratio and households savings ratio

The personal savings ratio measures the realised savings of the personal sector as a ratio of the total personal disposable income. This can be realised and shown in a mathematical equation:

$PersonalSavingRatio=\frac{realisedsavingorpersonalsaving}{personaldisposableincome}$

The household saving ratio is similar; this particular ratio only measures the household realised saving ratio as a ratio to their disposable income. It is important to realise that the personal sector includes unincorporated businesses such as partnerships or charitable organisations.

This savings ratio is important for economists and economic agents in the government as they wish to understand how much money people are willing and able to save as it could have an effect on the state of the aggregate demand.

Investment in aggregate demand

Unlike capital, which is characterized as a stock concept, investment is a flow concept. This means, for example, that for capital, we can measure the amount of stock available at a given point in time (it is essentially measuring the total of all capital goods of a nation that are still in production). The flow of investment is usually measured over some time, over one year.

A country usually has two types of investment:

• Replacement investment. In this form of investment, the country chooses to keep the existing amount of capital and replace the capital that is worn out, such as replacing a machine that doesn’t work anymore.
• Net investment. In this form of investment, the country chooses to add to the capital stock, such as investing in new machinery and factories, to increase production potential.
• Both the net investment and the replacement investment make up the country’s gross investment.

Factors influencing investment decisions

Investment can be classified into two types of physical capital goods:

• Investments of fixed capital (such as machinery, plants, or factories) and social capital (such as roads and socially owned hospitals).
• Inventory investments in stocks of raw materials such as iron, metal, lithium or other components necessary for production, semi-finished goods such as glass, gold or silver, and finished goods, electronics, food, etc.

• Other factors firms need to take into account when making investment decisions are:

  • Price of labour.
  • Price of capital (the cost of producing the capital as well as the cost of using the capital for the firm).
  • Technological development.
  • Expected future sales revenue attributed to the new machinery.
  • Expected costs of production from the machinery and interest payments made from the borrowing to fund the machinery in the first place.
  • Maintenance costs of the machinery.
  • Expected future profit to be yielded from the machinery.

Government spending in aggregate demand

Government spending is a key component of aggregate demand. The decisions of a government on where to spend the money can have a big regional impact to promote economic activity. It is also important that the government spends more money on the public to provide merit as well as public goods.

There are three forms of government spending:

• Welfare spending. Otherwise known as transfer payments. As an example, we can look at the welfare offered by the UK: social welfare services such as job seeker allowances, universal credit welfare rates, etc.

• Recurring spending. Otherwise known as public services such as police, fire brigade, state education, national health services, local authority services.

• State investments. Otherwise known as capital investments, this is spending on capital goods needed to provide public services such as infrastructure, public buildings, etc.

• Other main examples of government spending include the field of education where the state invests in building schools or public infrastructures such as roads, health care (hospitals), and defence (military).

Net exports in aggregate demand

Before looking at the concept of net exports let’s quickly revisit the definition of exports and imports.

Factors influencing the trade balance

1. Relative prices of goods and services in the world markets. For example, the prices of certain goods and services may vary between the UK and Germany or between the UK and China. Chinese goods and services will be cheaper, for example, due to the fact that the cost of production of these goods and services is vastly cheaper. Their quality is also lower than that of goods produced in Germany.

2. The exchange rate. Usually, a stronger currency makes exports more expensive as to buy the goods and services, a nation first has to acquire the necessary currency whose price is costlier in relation to the nation’s own currency. For example, if the Sterling pound were to appreciate and increase in value against the Euro, it would mean that European countries would have to first buy the costlier British pounds to import goods and services from the UK. In addition, from the UK’s point of view, imports from the European Union would become cheaper as the value of the British pound would have appreciated in comparison to the Euro.

3. Strength of aggregate demand in key export markets. If the UK exports 10% of its goods and services to the US due to strong trade ties, and the US, for example, enters a recession due to lower AD, it would be difficult for the UK to find new key export markets as aggregate demand for UK goods and services in the US would be low and UK exports towards the US would decrease.

4. Non-price demand factors, for example how effective and good are the designs, innovations, branding and performance of the goods and services that are being exported.

Aggregate demand and the level of economic activity

In this context, economic activity will also hold a relation to the employment levels in an economy as we are trying to realise the relationship between the aggregate demand and real output. When the real output increases, businesses have to hire more labour/workers in order to produce more goods and services, and that process alone involves a large labour supply. Conversely, when real output decreases, firms tend to demand less labour as there is little demand to produce these goods and services