Aggregate Demand What do you think aggregate demand (AD) is? – Aggregate means sum – Aggregate demand is therefore the total quantity of goods and services that will be bought in the UK at any given price over a period of time – Remember the circular flow of income – Household spending is after taxes and saving, so what is total demand

Aggregate Demand Consumption (C) is spending by households on goods and services. Largest component, accounting for over 60% of GDP Investment (I) is spending by firms on investment goods like factories and machinery Government spending (G) is spending on state provided goods and services such as defence and the NHS, plus investment such as building roads or schools (Not transfers like welfare which are measured in consumption) Exports minus imports (X – M) We are interested in spending on goods and services produced in the UK, so we include exports, but we must deduct spending on foreign produced goods since this is included in C, I and G and is not demand for UK goods and services So AD = C + I + G + X – M

Components of Aggregate Demand How significant are each of the components of Aggregate Demand? See LHS graph

Aggregate Demand Curve Price Level Real Output P1P1 Y1Y1 P2P2 Y2Y2 0 Why is the curve downward sloping? AD We label the x axis as real output, and use Y (short for National Income). Since Output Ξ Income Ξ Expenditure output of say Y 1 corresponds to spending as shown by the AD curve

Why downward sloping Three reasons: Real wealth. If prices rise, then the real value of a households wealth (such as money in the bank) falls, leading to a fall in consumption by households. Called the real balance effect. And vice versa Interest rates. When prices rise, interest rates rise. The theoretical reason is because the demand for money increases because the real value of money in bank accounts falls, but we can also think that the Bank of England will raise interest rates to combat inflation. Rising interest rates will reduce spending (C and I) Net exports. Higher prices means exports are less competitive and imports more competitive, so reduction in X–M. (Might also argue that the higher interest rates from an increase in the price level means a currency will rise in value, thus reducing X-M)

Movements and shifts Price Level Real Output P1P1 Y1Y1 P2P2 Y2Y2 0 AD 1 A movement along the Aggregate Demand curve happens when, all else equal, the price level changes

Movements and shifts Price Level Real Output P1P1 Y1Y1 Y2Y2 0 AD 1 A shift in the Aggregate Demand curve happens there is a change in any other relevant variable apart from the price level AD 2

Movement and shifts An increase in consumption can lead to either a shift or movement along the curve To decide whether it is a shift or movement you need to consider the reason for the increase in consumption or other component of AD – If the reason is because of a change in the price level, then it is a movement – If the price level has not changed, and so the change is for another reason, then it is a shift For example if UK consumes are happy today because it is sunny and they feel optimistic, they may spend more. C increases, so AD increases. This is a shift