AGGREGATE DEMAND

Theme 2 – The UK EconomyTextbook pages 144-151

What is Aggregate Demand? The total level of expenditure on all domestic goods and

services Consists of:

Consumption (C)+ Investment (I)+ Government expenditure (G)+ Export earnings (X)– Import expenditure (M)

Therefore, AD = C + I + G + (X – M)

AD Curve: The AD curve graphs the relationship between the price

level and real output Always slopes downwards

Inverse relationship between PL and RO

Net Exports

£bn per year at constant 2003 prices

The Components of Aggregate Demand

Consumer spending

Capital investment

Government consumption

Imports

Exports

Source: UK Statistics Commission

97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

thou

sand

billi

ons

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

GB

P (th

ousa

nd b

illion

s)

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

PL

RO

AD

The AD curve slopes downwards because:Purchasing power falls as the price level rises while incomes remain constant therefore less demand

Imports become relatively cheaper as the UK price level rises and are substituted for domestic demand

P1

P2

Y1 Y2

Lower price = Y1 to Y2 i.e. expansion in AD Higher price = Y2 to Y1 i.e. contraction in AD

Understanding why the AD Curve Slopes Downwards

Shifts in the AD Curve1. A result of an endogenous shock (Greek

for ‘coming from inside’) A change in a component of AD

2. A result of an exogenous shock, (Greek for ‘coming from outside’)

A change in a variable which affects at least one of the AD components, but which itself is outside the AD model

Effectively, a shift in AD shows how real output has changed independently of PL

External Shocks to Aggregate DemandMany unexpected events cause changes in

demand, output and employment. These events are called external “shocks”.

Price Level

Real Output

AD1

For a rightward shift of AD, there must be an increase in… Consumption, Investment, Government Spending or Net Exports

Evaluation: If there was a 10% increase in each component, which change would increase AD by the greatest amount?

AD2

AD3

Y3 Y1 Y2

P1

1. Real Income

This is the main influence on consumer expenditure. The Average Propensity to Consume (APC) is the proportion of

income that households devote to consumption APC = Consumption/Income or C/Y Example: Sarah’s wage after allowing for tax is £500 per

week; of this, she spends £450 per week in total. What is Sarah’s APC?

The Marginal Propensity to Consume (MPC) is the proportion of an increase in disposable income that households devote to consumption

The Marginal Propensity to Save (MPS) is the proportion of an increase in disposable income that households devote to saving

Take notes from p.146/147 and Qu.Skills 11.1, 11.2 What influences the MPC?

2. Wealth Leads to wealth effect – change in consumption

due to a change in the wealth of an individuals (either positive or negative)

3. Consumer Confidence/Expectations

4. Interest rates Lower interest rates = higher consumption due to:

It is cheaper for consumers to borrow It reduces the incentive to save People with mortgages have more money to spend.

Why may spending not always rise when interest rate falls?

5. Demographics Young/elderly typically have a high APC –

why?

6. Distribution of income Poor people spend a higher proportion of

their income than rich people – why?

7. Income tax level

8. Unemployment rates

Investment Increased business confidence (economic

cycle) Increased profitabilityLow risk business environment e.g.

political instability / election Falling IR e.g. 2009 – 0.5% Government policies promoting

investment – e.g. investment subsidies or Enterprise Zones (Docklands, 1980s)

Key Question: how easy is it for government to control investment levels?

Public sector debt is owed by central and local government and by public (state-owned) corporations Debts owed by state-owned banks are included in national

debt Private sector debt is owed by private businesses

and households. Companies may have borrowed to finance investment

(corporate sector debt) Households have loans for example credit card debt and

mortgages on properties. Financial debt is also part of the private sector –

this is the outstanding (unpaid) debts of banks and financial corporations - for example the level of bad debts on loans to businesses and to the housing market

Public and Private Sector Debt

In the spring of 2013, household and non-financial firms’ debt amounted to 208% of UK GDP – down to levels last seen in mid-2007, but significantly higher than they were a decade ago (170pc of GDP) and 15 years ago (128pc of GDP).

The UK private debt/GDP ratio is high by historical and international standards, and far above the 160% level used by the EU Commission as a threshold for gauging imbalance in debt to income levels for EU member states.

The Scale of Debt in the UK Economy

UK Household Debt Relative to Disposable Incomes

• Short term loans include outstanding debt on credit cards

• Long term loans include mortgage debt

Debt acts as a constraint on future spending power. Millions of people in the UK are saddled with many

thousands of pounds of debt and the interest payments on this debt reduces their effective disposable income

The commercial banks also have high debt and this restricts their ability to make fresh loans to businesses and households who want to borrow. This can limit business investment

The economy can be at risk with a high debt-to-GDP ratio If price deflation happened, falling consumer prices and

incomes would make the debt problem even worse in real terms

When nominal interest rates rise, many households – especially mortgage payers - are at risk and can struggle to meet repayments. This could cause a slowdown or a possible recession in the housing market.

Consequences of Debt for an economy such as the UK

Government spending Change of Gvt policy, leading to a rise in Gvt spending,

e.g…. NB: This does not include spending on transfer payments.

Exports – imports A rise in UK (external) price competitiveness, e.g.

Fall in sterling ER Fall in IR (which leads to a fall in sterling ER)

A rise in the UK’s non-price competitiveness, e.g. better Quality and reliability Innovation and technology e.g. Dyson Branding

Economic boom abroad (major trading partners or globally)

Q: Examples of changes in recent history? Q: What will determine the scale of the impact of change in the exchange

rate on net exports?

Exports – Imports (evaluation – J curve) In the SR a change in the exchange rate will not

immediately change net exports, there is a time lag

In the SR there will be a low PED for imports and exports, this is due to most large trade deals being fixed contracts.

A depreciation in the £ vs a trading partner will make… imports more expensive but in the SR we still are committed

to purchase these, therefore we spend more on them and the value of imports rises (volume remain constant)

Exports cheaper but in the SR demand will be unresponsive due to fixed contracts so exports earnings do not compensate for the rise in import expenditure

AD: The specifics1. An increase in the price level in the UK is likely to lead to more

goods being imported and fewer being exported. Why does AD not shift left?

2. What is meant by the terms ‘endogenous’ and ‘exogenous’ factors?

3. Why does a rise in the value of an individual’s assets lead to an increase in consumption?

4. Which form of government spending should not be included as part of AS/AD analysis?

5. ‘Investment’ is one component affecting AD. What is meant by this term in the context of AD/AS analysis?

6. How is a rise in the interest rate likely to affect the exchange rate and hence AD? How can this point be evaluated?