2.5 The Determinants of Aggregate Demand What is meant by the term aggregate? What is macroeconomics the study of?

2.5 What you need to know The concept of aggregate demand The determinants of aggregate demand The determinants of saving The difference between saving and investment The concept of the accelerator

2.5 You should be able to: Define aggregate demand Explain and analyse the determinants of aggregate demand Illustrate the effects of changes in aggregate demand on a diagram Explain and analyse the determinants of saving in an economy Explain the difference between saving and investment Briefly explain the role of accelerator in an economy

Aggregate Demand: A Definition Recap. What is the shape of a normal demand curve? Why is it downward sloping? What does ‘aggregate’ mean? “The total demand for all goods and services in an economy at any given price level over a period of time”. Class estimate: What do you think is the total value of demand for goods and services in the UK?

The Aggregate Demand Curve Price Level Real National Output AD P Y Building diagrams: Axis? AD Curve? Labels? The price level is the average of prices for all goods and services in an economy. Real national output is the output of the economy taking into account inflation. We can use the formula: Nominal (Money) National Output Average Price Level

The Components of Aggregate Demand Aggregate Demand (AD) has 4 main components It is crucial to know and understand these in order to analyse AD more closely 1. Consumption (C) 2. Investment (I) 3. Government Spending (G) 4. Net Exports (Exports – Imports) (X-M)

The AD Formula AD comprises the sum of each of these 4 components: C + I + G + (X-M)

The Composition of AD Which of the 4 components of AD do you think contributes the most to the UK economy? Which contributes the least? Source: ONS Consumption Investment Government Spending Net Exports

Consumption (1) Income Higher levels of disposable income will normally lead to greater levels of consumption as individuals can afford more goods and services Disposable income will change depending upon, for example, tax or wage rates Interest rates Lower interest rates will normally increase consumption as saving becomes less attractive, loans become more affordable and individuals with variable rate mortgages see monthly disposable income increase Levels of personal debt If individuals have low levels of personal debt e.g. credit cards or loans they will normally consume more as less disposable income is diverted to repayments What determines the level of consumption in a household?

Consumption (2) Levels of personal wealth Individuals with higher levels will tend to consume more as they can borrow funds against the value of assets e.g. their house Confidence If individuals have confidence in their short, medium and long term economic prospects, it is likely that they will increase their spending This is often linked to their employment prospects or job security Marginal propensity to consume/save This refers to how likely an individual is to consume or save an extra £1 of income they receive It is usually dictated by a combination of the above factors

MPC/MPS If I gave you £100 today what would you do with it? What is your marginal propensity to consume? What is your marginal propensity to save? What factors influence your MPC and MPS?

Consumption is the largest, and thus the most important, element of AD. It is a major driver of the economy. The Pattern of UK Consumption £bn Source: ONS

Saving Whilst not a component of aggregate demand, the level of saving in an economy has a direct impact upon the level of consumption, and hence, aggregate demand In economics, any disposable household income that is not used for consumption is said to have been saved Why are women saving less than men?

Determinants of Saving Interest rates Higher interest rates increase the incentives to save as the reward is greater Confidence If individuals and workers are nervous about the future, they may be inclined to save more of their income in the event of wage cuts, wage freezes or redundancy Inflation If prices are rising quickly, then the real value of savings is eroded, so the incentive to save reduces

Investment (1) Spending by firms on capital goods Important note – Investment is not to be confused with investment by an individual in stocks, shares or bonds. In economics, investment is only concerned by firms with the aim of improving capital in terms of quantity, quality or efficiency. What determines the level of investment by firms?

Investment (2) Interest rates Lower interest rates make investment projects less costly and normally help to stimulate investment Confidence If firms are confident in future economic prospects and the likelihood of consumption increasing, they are more likely to invest in capital projects Government incentives Businesses may be able to take advantage of government grants to compliment their own investments This often applies to new business start-ups or businesses locating in an area of social deprivation

Investment (3) Economic growth The faster the pace of economic growth, the sooner capital equipment will wear out or require replacement, so investment increases Profit levels Higher profit levels will often be re-invested to maintain a firm’s growth Price of capital equipment If the price of capital equipment falls relative to the cost of labour, it may make investment projects more attractive Technology The requirement to keep up to date or gain competitive advantage through technological advances may drive new investments

The Pattern of UK Investment Source: ONS

The Accelerator The accelerator effect shows the relationship between Gross Domestic Product (GDP) and the rate of investment It states that a rise in GDP will lead to a proportionately larger increase in investment Why might this happen? If a firm sees that GDP and AD is increasing, it needs to be certain that this is going to be sustained Initially, the firm will use their existing capacity and make their existing capital and labour force work harder to meet this growing demand At some point, the firm will reach full capacity, and if they believe that growth will be sustained, they will invest in capital equipment to meet future anticipated demand This increase in investment will boost AD still further and assist yet more economic growth

Government Spending Tax revenue and borrowing spent by the government for the benefit of the country’s citizens The precise levels of government spending, and the areas of the economy that have money spent on them, will vary according to the government’s reading of economic conditions and the varying priorities of the government of the day Why is the current government making spending cuts?

Net Exports (Exports – Imports) We are only concerned with demand and output generated within a country, hence imports are deducted What determines the level of Exports and Imports ? Write down as many variables as you can.

Net Exports (Exports – Imports) UK productivity If the UK is more productive and efficient in the production of goods and services, it is likely we will be more competitive in global export markets Exchange rates A strengthening currency will make UK exports less competitive Demand may fall A stronger currency will also make imports more attractive to UK consumers and they may increase Net exports will therefore worsen A weaker currency should have the opposite effect and improve net exports Economic growth in other countries Strong economic growth in key export markets e.g. Europe, USA and China gives opportunities for UK firms to export goods and services to new markets Extent of free trade As free trade broadens e.g. enlargement of the EU this gives rise to new export opportunities

Shifts and Movements of the AD Curve A change in the price level leads to a movement along the AD curve Shifts in the AD curve will occur if there is a change in any of the components of AD (C, I, G, X or M)

Movements Along the AD Curve Price Level Real National Output AD P Y P2P2 P1P1 Y1Y1 Y2Y2 A rise in the price level leads to a contraction in aggregate demand. A fall in the price level leads to an expansion in aggregate demand.

Shifts of the AD Curve Price Level Real National Output AD P YY2Y2 Y1Y1 An increase in any of the components of AD will lead to a shift from AD to AD 1. AD 2 AD 1 A decrease in any of the components of AD will lead to a shift from AD to AD 2.

Multiple Choice 1 In the short run, a decrease in aggregate demand is most likely to be caused by a growth in a) exports b) imports c) consumption d) investment Can you explain your answer?

Multiple Choice 2 In economics, investment is best defined as a) the flow of money into the stock of savings b) spending on capital goods in an economy c) the profit kept back by firms to finance future expenditure on new machinery and equipment d) the stock of economic resources such as factories and machinery Can you explain your answer?

Multiple Choice 3 Aggregate demand has increased in an economy. Which of the following combinations would be most likely to cause the increase? Can you explain your answer? Household Savings Business Investment ARiseRises BRiseFalls CFallFalls DFallRises

Multiple Choice 4 Which of the following statements concerning UK investment is correct? a) Increased investment leads to a reduction in saving b) Investment is the largest component of aggregate demand c) Investment is a withdrawal from the circular flow of income d) Investment can increase the capital stock of the economy Can you explain your answer?

2.5 You should be able to: Define aggregate demand Explain and analyse the determinants of aggregate demand Illustrate the effects of changes in aggregate demand on a diagram Explain and analyse the determinants of saving in an economy Explain the difference between saving and investment Briefly explain the role of accelerator in an economy