An Introduction to Aggregate Demand

AS and A Level Economics

Macroeconomics H/W 3 – An Introduction to Aggregate Demand

The formula for AD is C + I + G + (X-M)

C – Consumer expenditure – spending by households on consumer products (e.g. clothing, food and insurance).

I – Investment – spending on capital goods.

G – Government spending – spending by the central government and local government on goods and services.

X – Exports – products sold abroad.

M – Imports – products bought from abroad.

(X-M) – Net exports – the value of exports minus the value of imports.

b) Consumer expenditure, or consumption, is the largest component in most countries. It is basically spending by households on consumer goods and so tells us how much vaguely how much demand there is for these certain goods. Investment is similar, except capital goods are bought instead of consumer. It is the most volatile component of AD, as it may rise by 60% on year, but fall by 20% the next year. Government spending does not include transfer payments or job seeker’s allowance as they do not involve the government itself buying goods and services.Net exports add foreigners’ spending on the country’s goods and services and deduct spending by the country’s population on imports. This component can be positive or negative.

c) 3 determinants of Consumption (C):-

- Real Disposable Income: main influence on consumer expenditure. The rich tend to spend more than the poor as they have more disposable income. However, their APC (average propensity to consume) may fall as they will probably spend a smaller percentage of their income than a poorer person.

- Consumer confidence: This may have a significant influence on consumption, as households tend to spend more if they are optimistic about the future and expecting good job prospects or high wages. This may lead to their proportion of income rising whilst their income is rising.

- Interest rates and inflation: ...

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- Interest rates and inflation: Usually a fall in interest rates will stimulate a rise in consumer expenditure as it is cheaper to borrow in order to buy expensive items; it reduces the incentive to save because by spending people are giving up less interest; and those who are paying interest on a mortgage will have more money to spend. Inflation however, can oppose the fall in interest rates. If inflation increases, some people may save so they can maintain the real value of their savings. However, an increase in inflation could also lead to increased spending as people may expect prices to increase in the future.

d) 3 determinants of Investment (I):-

- Changes in real disposable income: if this is increasing, demand for consumer goods and services may also be increasing so this may encourage firms to invest in capital in order to expand their capacity. However, firms need to believe that the rise in demand will last and that their existing capital goods are not sufficient to produce the extra output.

- Expectation: firms are more likely to invest if they feel optimistic about future economic prospects. The extent and speed of changes in expectations are the main reasons for the volatility of investment.

- Capacity utilisation: firms may look to invest if they are currently operating at close to full capacity. However, in contrast, if they have considerable spare capacity, they may be able to increase output without buying new capital.

e) 3 determinants of exports (X):-

- Real disposable income abroad: a rise in income abroad is likely to result in more exports being sold. E.g. the USA is one of UK’s main trading partners. If people in the USA enjoy higher disposable income, they will buy more goods and services, some of which will come from the UK.

- The exchange rate: As well as being influenced by the inflation rates, the price of exports and imports are also affected by exchange rate changes. A fall in a country’s exchange rate will reduce the price of exports and raise the price of imports (and vice-versa). This may lead to a rise in export revenue and fall in import expenditure.

- Government restrictions on free trade: a country’s net exports may rise if other countries’ governments remove trade restrictions. E.g. China might be able to export more steel to the USA if the US government removed tariffs on Chinese steel. This may lower the price of steel from China on the US market and so make the price more competitive.

a) A fall in the base rate of interest generally stimulates a rise in consumer expenditure, and therefore an increase in AD, because it makes it cheaper for consumers to borrow in order to buy expensive items like cars, and it reduces the incentive to save, as by spending people are giving up less interest. It is also because those who are paying interest on a mortgage or any other loan will have more money to spend. And although net savers’ ability to spend will fall, their fall is usually offset easily by the rise in spending from borrowers.

b) An increase in the savings ratio would result in higher savings in proportion to disposable income. This means that the real disposable income will decrease, as more people will be saving rather than spending in general. Therefore, if less people are spending, consumption (a component of AD) will be affected as it will decrease, hence resulting in the AD to shift to the left.

c) An increase in house prices may make homeowners wealthier as their house would be worth more. This increases consumer confidence and encourages them to spend more and hence increasing consumption. This would shift the AD to the right. Another way increasing house prices will also lead to an increase in AD would be because a rise in house prices tends to lead to an increase activity in the housing market, i.e. more people choose to buy or sell their house. Thus, a new house would probably mean new furniture and household accessories, hence increasing spending in those markets. As AD would increase, the graph would look similar to that in part (a).

d) A recession in North America may lead to fewer exports by the UK as the USA is a major consumer of the UK’s products. This would be because there would be less disposable income in the USA and therefore it would be unnecessary for the USA to buy our products as many of them will remain unused or not purchased. Consumer confidence in the USA would be low as people may be scared about losing their jobs. Therefore, as the USA is one of the UK’s main trading partners, there would be fewer exports overall by the UK. Therefore, people living the UK’s net exports would be lower, and so the AD would shift to the less as it would decrease. The shift in the AD graph will be similar to that in part (b).

Peer Reviews

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groat

28th of Feb 2012

Quality of writing

The essay is structured well, addressing a new point in each paragraph. I liked how this essay doesn't repeat itself, but uses the previous paragraphs to back up their new points. This makes for a convincing argument and a flowing style. Spelling, punctuation and grammar are strong.

Level of analysis

The analysis in this essay is strong. This is due to the discussion of the determinants for each component. I liked how there was a discussion of which component is largest, yet they could've built upon this to make a simple judgement on which component is most significant. Doing so would've gained credit for evaluative skills and a perceptive debate. Each determinant is explained well, with the mechanism clearly shown. I would note that it's important in Economics not to jump any steps, as this shows a lack of understanding, suggesting to the examiner you have simply rote learned it from a textbook. I liked how this essay looked at a number of scenarios affecting aggregate demand, using diagrammatical analysis to show the affect on real GDP. It is important to explain why the aggregate demand curve will shift, and this essay does this extremely well. They start with the change, for example a decrease in the interest rate. They then say how this affects consumption, rather than simply stating it will. If I were doing this essay, I would be slightly more explicit in saying that consumer expenditure is a component of aggregate demand, thus an increase in this will cause a right shift in aggregate demand. It may be useful to look at the multiplier effect to gain the highest marks!

Response to question

This essay engages with the question superbly. There is a clear understanding of the composition of aggregate demand, shown by an inclusion of the formula and the components. I would've liked to have seen a definition of aggregate demand, along the lines of "the total demand for goods and services in the economy at any given price level". There is plenty of analysis of the components which contribute to aggregate demand, but a short definition would make for a strong introduction.

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