1. AS: 3.2.2 How the macroeconomy works
2.2.3 The determinants of aggregate demand
What is meant by the term aggregate?
What is macroeconomics the study of?
AS: How the macroeconomy works

2. 2.2.3 The determinants of aggregate demand
What is meant by AD
The determinants of AD, i.e. the determinants of consumption, investment, government spending, exports and imports
The basic accelerator process
The determinants of savings
The difference between saving and investment
You will not be required to undertake calculations to illustrate the operation of the accelerator
You should understand how changes in net exports affect AD and how global events affect economic performance

3. Aggregate Demand: A Definition
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?

4. The Aggregate Demand Curve
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
Price Level
Real National Output AD P Y

5. 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
Consumption (C)
Investment (I)
Government Spending (G)
Net Exports (Exports – Imports) (X-M)

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

7. What determines the level of consumption in a household?
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

8. 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

9. 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?

10. Changes in household spending
Durables includes spending on household goods and vehicles, photographic, communications and other recreational equipment, therapeutic appliances and valuables. Semi-durable goods include clothing and footwear, household textiles and some household appliances, as well as games, toys and hobbies. Non-durable goods include food and drink, housing maintenance and utilities, fuel and items for recreation and culture (including newspapers, garden plants and flowers and pet related products). Services comprises of actual and imputed rentals for housing, transport, health, cultural and communications services, as well as restaurants, accommodation and financial services.
Household Final Consumption Expenditure (HHFCE) is an estimate of household spending.

11. Trends in household spending (2001-2013)
Consumption is the largest, and thus the most important, element of AD.
Why do you think that spending on fuel and power has increased over the period?

12. 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
A nation of savers?

13. 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

14. What determines the level of investment by firms?
Spending by firms on capital goods
Important note – Investment is not to be confused with investment by an individual in stocks, shares or bonds. This would be regarded as saving. 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?

15. Government incentives
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

16. 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

17. Business Investment growth (2007-2014)
Business investment made a significant contribution to GDP growth between 2013 and 2014.
Investment in the service sector contributes more than any other sector of the economy.
Source: Bank of England

18. 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

19. Why is the current government making spending cuts?
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?

20. 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.

21. 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

22. The UK’s trading partners (3 month view)
Use the UK Trade Info website to find up to date information.

23. How global events affect economic performance
The position on the economic cycle of our major trading partners will impact on the demand for UK goods and services
If they are in recession then demand for UK exports will fall
This will severely impact on those businesses that trade globally
A fall in demand will impact on other areas of the economy
The knock-on effects can lead to recessionary pressures in the UK
As the e-global economy moves into recovery exporters will invest more, confidence will improve and their will be growth in the UK economy

24. 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)

25. Movements Along the AD Curve
Price Level
Real National Output AD P P2 P1
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. Y1 Y Y2

26. Shifts of the AD Curve
An increase in any of the components of AD will lead to a shift from AD to AD1.
Price Level
Real National Output AD P
AD2
AD1
A decrease in any of the components of AD will lead to a shift from AD to AD2. Y2 Y Y1

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

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

29. 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 A
Rise
Rises B
Falls C
Fall D D

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