2.2.1 The characteristics of AD Flashcards
Aggregate Demand AD
Aggregate demand (AD) is the total level of spending in the economy at any given price.
Components of Aggregate Demand
AD=C+I+G+(X-M)
Consumption
Investment
Government spending
Net trade exports
Consumption: AD
Consumption is consumer spending on goods and services; it makes up about 60% of AD, so is the biggest part.
Investment: AD
Investment is spending by businesses on capital goods, such as new equipment and buildings as well as working capital e.g. stocks and work in progress; it makes up about 15-20% of AD. Most investment is by the private sector (about 75%) but there is also investment by the government.
Government spending: AD
Government spending is spending by the government on providing goods and services, generally public and merit goods, both on wages and salaries of public sector workers and on investment goods like new roads and schools. This will change year on year as governments decides how much they spend. Transfer payments such as pensions and jobseekers’ allowances aren’t included in the figure as money is just transferred from one group to another. Government spending tends to be around 18-20% of GDP.
Net exports: AD
Net exports is exports minus imports: when imports are higher than exports this is a minus figure as more money leaves the UK than comes in. The UK has a large trade deficit, but this minor figure and is the least significant part of AD at around 5%.
AD curve
The AD curve is the same as the demand curve for an individual market, but instead of showing the relationship between price and output, it shows the relationship between price level and real GDP. Like the demand curve, the AD curve is downward sloping as a rise in prices causes a fall in real GDP and there are four key reasons for this:
Income effect
Substitution effect
Real balance effect
Interest rate effect
Income effect: AD downward curve
As a rise in prices is not matched straight away by a rise in income, people have lower real incomes so can afford to buy less, leading to a contraction of demand.
Substitution effect: AD downward curve
If prices in the UK rise, less foreigners will want to buy British exports and more UK residents will want to buy imported foreign goods because they are cheaper. The rise in imports and fall of exports will decrease net exports so AD will contract.
Real balance effect: AD downward curve
A rise in prices will mean that the amount people have saved up will no longer be worth as much and so will offer less security. As a result, they will want to save more and so reduce their spending, causing a contraction in AD.
Interest rate effect: AD downward curve
Rising prices mean firms have to pay their workers more and so there is higher demand for money. If supply stays the same, then the ‘price of money’ i.e. interest rates will rise because of this higher demand. Higher interest rates mean that more people will save and less will borrow and will also mean that businesses invest less, so AD will contract.
Movements and Shifts along AD curve
Like with demand, there can be movements in the AD curve or there can be shifts. A movement along the AD curve is caused by a change in prices, caused by inflation or deflation. A shift of the AD curve is caused by a change in any other variable. Again, as with demand, a shift to the right represents an increase in AD and a shift to the left represents a fall in AD.
Rates of change vs Absolute change: AD
It is important to distinguish between rates of change and absolute change: a fall in the amount of consumption will reduce AD but a fall in the rate of rise of consumption means that consumption is still rising so AD will still increase but by not as much.
Movements as well as Shift in AD curve (e.g. interest rates)
Some factors, for example interest rates, could cause a movement or a shift in the AD curve. When prices increase, interest rates rise (because of the interest rate effect) and this causes a movement along the AD curve but if the government increases the interest rate then there is a shift in the AD curve. It is important to always look at whether the change is because of price or not.
