Aggregate Demand

University Degree Business and Administrative studies

“A country’s standard of living depends upon its ability to produce goods and services.” (Mankiw, N.G., 2001). In macro, aggregate demand is the total spending on goods and services produced in the economy over a period of time.

This essay focuses on the aggregate demand. In the first part, the essay will give the definition of aggregate demand and explain it in details. In addition, the AD curve is included and analysed carefully. The second part is to explain the relationship between the level of aggregate demand and the rate of economic growth. There are four parts of AD to influence the growth of economy. Lastly, I will examine the relationship between aggregate supply and the rate of economic growth in the long-run.

Aggregate demand equals C + I + G + (X - M). C indicates consumer spending on UK produced goods and services; I indicates investment spending in both public and private sector; G indicates government spending on other goods and services which excludes transfer payments because they are not a payment to a factor of production for output produced; X indicates exports, which equals overseas spending on UK produced output; M indicates imports, which is the UK spending on overseas output.

The circular flow of income illustrates the linkages between these different elements and depicts the flows of money around the economy. “The British economy comprises millions of individual economic units - households, firms and government. Together their decisions generate spending, output and income - three ways of measuring the total economic activity.” ().

As it is shown in the graph below, money flows from firms to households in the form of factor payments, and back again as consumer spending on domestically produced goods and services. However, in real world, not all income gets passed on around the inner flow between firms and households. Some income is withdrawn and at the same time some is injected into the flow from outside.

Circular Flow of Income

“There are indirect links between saving and investments, taxation and government expenditure, and imports and exports, via financial institutions, the government (central and local) and foreign countries respectively.” (Sloman, 2006, p372). As for UK, if more money is saved, it will be more available for banks and other kind of financial institutions to lend out; if tax is higher, UK government would be more likely to increase its spending; and if imports increase, foreigners’ incomes would increase, therefore they may tend to purchase more of UK’s exports.

In its turn, there is another formula. “C is assumed to take place out of net-of-tax income (Y - T), and income is not spent must, by definition, be saved (S). Thus, C = Y – T – S.” Then, the equation will be: “I = S + (T - G) + (M – X)”. In other words, investment in UK economy must be financed either by domestic savings (S), a “budget surplus” (T greater than G) or by running a balance of “payment deficit” (M greater than X). (Curwen, 1997, p27).

Unlike micro-economics, which focuses on individual markets, macro-economics ...

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Unlike micro-economics, which focuses on individual markets, macro-economics examine the economy as a whole, which deals in aggregates (totals). The “National Income Identity” is the fundamental concept in macro-economics. The total output, total incomes and total spending are always equal. Therefore, to use the expenditure method to calculate GDP is to calculate the aggregate demand. From the statistics showed in the following table, I can calculate that the UK GDP in 2004 was about £1100000 millions.

In reality, changes in demand not only affect output, but also influence prices. “The downward slope of the AD curve captures the inverse relationship between inflation on the one hand, and short-run consumption on the other hand.” (Frank & Bernanke, 2003).

An increase in the inflation rate leads to a contraction of AD. This is mainly because a rise in inflation will be met by a rise in interest rates. The UK government give Bank of England the responsibility for monetary policies in particular to control inflation at the government target level. This makes borrowing more expensive. Therefore C will be reduced, especially the spending on durables, and I will decreases because of the reduction in NPV of investment projects. In addition, a rise in inflation increases the exchange rate. A stronger pound will make exports more expensive, reducing their volume, and imports cheaper, increasing their volume. Therefore net exports (X-M) fall.

“Economic Growth is the increase in the output of goods and services produced by an economy” (Griffiths &Wall,1993). The rate of economic growth is the growth of the output in current year than the previous year, which equals the annual percentage increase in real GDP. It measures the volume of output, and the purchasing power of income and spending.

In the short-run aggregate demand is the independent variable. Variations in AD cause output and income to fluctuate around the equilibrium growth path. This is known as the Business Cycle. “The Business Cycle is the fluctuation of the total output, the total income and the total employment.” (Plosser, 1999, p57-77). In macro, the business cycle occurs at the condition that the Real GDP has an increase or decrease than the Nominal GDP. The following table shows the actual GDP in the model of the business cycle.

The dashed line indicates the Equilibrium GDP, and the real line indicates the Real GDP. Boom stage and recession stage are two important parts in the business cycle. The shifts in AD curve show the influences to the growth of economic. Recall the concepts of the circular flow of income. Provided that injections equals withdraws, and the speed of the cycle not change, then the GDP would be fixed. “If injections exceed withdraws, the level of expenditure will rise: there will be a rise in aggregate demand.” (Sloman, 2006, p372). In other words, national income will rise.

Shifts in the AD curve are caused by changes in four factors. Here, take the recession stage for example to analyse the condition. The first variation is the consumption. In the recession stage, generally speaking, the consumption has a large decrease. At the same time, stocks of cars and other durable products will increase because firms cut down the output. Afterward the investment also has a large decrease. Thus firms will pay less in wages, profits, rent and interest, the Real GDP will decrease.

The second variation is the employment. During the recession stage, the number of employment reduces a lot. The average of working time would decrease and the rate of employment could increase. The third variation is the output. The decreasing of output will lead the inflation to take a slow pace. The price of material will become low. So the growth of economic will slow. The last variation is the interests of enterprise. In the short-run, the interests have a change sometimes. If the interest decreases, the price of stock will reduce. Meanwhile, some contented areas come out the decrease. The decease of the economy happens.

“Potential growth is the speed at which the economy could grow. It is the percentage annual increase in the economy’s capacity to produce: the rate of growth in potential output” (Sloman, 2006, p378). It could occur if, first, there is an increase in the quantity of resources. It includes an increased stock of capital goods, an increased size of the labour force and discovery of new natural resources. Second, there is an increase in the productivity or efficiency of resources. Economic research indicates that increases in productivity are the main cause of growth, and the main reason for increased productivity is improvements in technology. More fundamentally, the economic system is a major determinant of growth (Hirsch, F. 1977).

The aggregate supply curve shows the amount of goods and services that firms are willing to supply at each level of prices. The view is that wages and prices are perfectly flexible in the long-run. “The LRAS is therefore vertical.” The SRAS curve will shift to the left if wage rates or other costs rise independently of a rise in aggregate demand. The LRAS curve will also shift to the right if either of the above factors increases. This is equivalent to the outward shift in the Production Possibility Curve illustrating economic growth.

The inflation rate and the level of real national output are simultaneously determined by the interaction of AD and AS. The business cycle is caused by shifts in AD or SRAS.

The short-run effects of an increase in demand are to cause an extension of supply (A to B). However this is only a short-run equilibrium. Once wages and other input costs adjust, the SRAS curve will shift and the economy moves to point C. There is a growth gap between potential and actual output. To close the gap, the actual growth rate would temporarily have to exceed the potential growth rate. “In the long-run, the actual growth rate will be limited to the potential growth rate.” (Sloman, 2006, p378).

The economy will grow with stable inflation providing AD rises at the same rate as AS. This is the equilibrium growth rate. Fiscal and monetary policies are designed to manage AD, and supply-side policies to speed up the increase in AS.

To sum up, aggregate demand is the total demand for final goods and services in the economy during a specific time period and a given . The aggregate demand curve shows the relationship of the level of output and the level of price at the condition of the equilibrium of the products market and money market. Economic Growth is the increase in the output of goods and services produced by an economy. There are many reasons to cause the growth of economic.

References:

Curwen, P., (1997) Understanding the UK Economy, 4th Edition, Macmillan: Hampshire
Frank, R.H. & Bernanke, B.S., (2003) Principles of Economics, 2nd Edition, McGraw-Hall: Irwin
Griffiths, A. & Wall, S., (1993) Applied Economics, 5th Edition, Longman Publishing: New York
Hirsch, F. (1977).The Social Limits to Growth, Routledge: London
Mankiw, N.G., (2001) Principles of Economics, 2nd Edition, Harcourt College Publishers: Florida
Plosser, C.I., (1999) “Understanding Real Business Cycles”, Journal of Economic Perspectives, vol.3, P57-77.
Sloman, J., (2006) Economics, 6th Edition, Prentice Hall: London
, 20th Apr 2008

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