8.

Understanding Aggregate Demand

You wont spend too long on a macroeconomic course before you come across the term aggregate demand! Aggregate means total and in this case we use the term to measure just how much is being spent by all of the major players in the economy consumers, businesses, the government and people and firms overseas. The Components of Aggregate Demand Aggregate demand measures total spending on goods and services. The identity for calculating aggregate demand (AD) is as follows: AD = C + I + G + (X-M) Where C: Consumers' expenditure on goods and services: Also known as consumption, this includes demand for durables e.g. washing machines, audio-visual equipment and motor vehicles & non-durable goods such as food and drinks which are consumed and must be re-purchased. Consumer spending is the biggest single component of aggregate demand. I: Capital Investment This is investment spending on capital goods such as new plant and equipment and buildings which will allow us to produce more consumer goods in the future. Investment also includes spending on working capital such as stocks of finished goods and work in progress. Capital investment spending in the UK accounts for between 16-20% of GDP in any given year. Of this investment, 75% comes from private sector businesses such as Tesco, British Airways and British Petroleum and the remainder is spent by the government for example investment in building new schools or in improving the railway or road networks. So a mobile phone company such as O2 spending 100 million on extending its network capacity and the government allocating 15 million of funds to build a new hospital are both counted as capital investment. Investment has important effects on the supply-side as well as being an important although volatile component of aggregate demand. A small part of investment spending is the change in the value of stocks i.e. unsold products. Producers may find either than demand is running higher than output (i.e. stocks will fall) or that demand is weaker than expected and less than current output (in which case the value of unsold stocks will rise.) G: Government Spending This is spending on state-provided goods and services including public goods and merit goods. Decisions on how much the government will spend each year are affected by developments in the economy and the political priorities of the government. Government spending on goods and services is around 18-20% of GDP but this tends to understate the true size of the government sector in the economy. Firstly some spending is on investment and a sizeable slice (nearly 190 billion in 2007) goes on welfare state payments. Transfer payments in the form of benefits (e.g. state pensions and the jobseekers allowance) are not included in general government spending because they are a transfer from one group (i.e. people in work paying income taxes) to another (i.e.

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pensioners drawing their state pension having retired from the labour force, or families on low incomes). The next two components of aggregate demand relate to international trade between the UK economy and the rest of the world. X: Exports of goods and services - Exports sold overseas are an inflow of demand (an injection) into our circular flow of income and spending adding to aggregate demand. M: Imports of goods and services. Imports are a withdrawal of demand (a leakage) from the circular flow of income and spending. Net exports measure the value of exports minus the value of imports. When net exports are positive, there is a trade surplus (adding to AD); when net exports are negative, there is a trade deficit (reducing AD). The UK has been running a large trade deficit for several years now as has the United States. Our table below shows the components of aggregate demand that we have covered in this chapter. Components of Aggregate Demand for the UK Economy Consumer spending Government consumption Gross Investment Change in stocks Exports of goods and services billion 238.3 247.3 269.8 277.7 280.6 285.4 299.3 323.7 358.4 Imports of goods and services billion 238.8 257.8 281.1 294.4 308.7 314.8 335.7 359.6 394.8 Real GDP

billion 1999 2000 2001 2002 2003 2004 2005 2006 2007 579.3 606.6 633.7 653.3 676.8 697.2 721.4 732.0 745.7

billion 198.6 205.9 212.3 217.4 224.9 232.7 240.1 246.5 250.6

billion 164.2 169.1 173.7 178.2 184.7 186.7 197.7 200.7 216.0

billion 4.3 5.8 4.6 5.6 2.3 4.0 4.6 3.6 2.4

billion 973.7 1003.4 1041.5 1066.2 1088.1 1118.2 1154.7 1175.9 1210.3

Source: Office for National Statistics and HM Treasury Consumer spending as a share of GDP has grown from 59.4% of real GDP in 1999 to 61.6% in 2007. Although this might seem like a small percentage change, because the scale of consumer demand is so huge (in 2007 it amounted to over 2 billion per day!) then a shift in the share of GDP towards household spending has had a major impact on the economy. Much of this extra demand has gone on imported products leading to a rising trade deficit. But it has also been spent on domestically supplied goods and services providing a boost to the home economy. If consumer

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spending was to fall in real terms, then the risks of a recession in the UK would be much higher. We will return to this in our chapter on consumer spending. Shocks to the level of aggregate demand One of the really interesting things about being a macroeconomist is that lots of unexpected events can happen which cause changes in the level of demand, output and employment. The headwinds can alter direction with great speed leading to uncertainty about where the economy is heading. These unplanned events are called shocks and many of them happen in other countries or parts of the global economy but they have an effect across many different countries. One of the causes of fluctuations in the level of macroeconomic activity is the presence of demand-side shocks. Some of the main causes of demand-side shocks are as follows: o o A capital investment boom e.g. a construction boom to increase the supply of new houses or to build new commercial and industrial buildings. A big rise or fall in the exchange rate affecting net export demand and having follow-on effects on output, employment, incomes and profits of businesses linked to export industries. A consumer boom abroad in the country of one of our major trading partners which affects the demand for our exports of goods and services. A large slump in the housing market or a slump in share prices. An event such as the international credit crunch involving a sharp fall in the amount of credit available for borrowing by households and businesses. An unexpected cut or an unexpected rise in interest rates or change in government taxation.

o o o o

These shocks will bring about a shift in the aggregate demand curve and we turn to this next. The Aggregate Demand Curve The AD curve shows the relationship between the general price level and real GDP. In most macroeconomics textbooks the aggregate demand curve is drawn as a straight line but you can draw a curve as well. Dont worry the examiners will accept both versions!

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The AD curve shows the relationship between aggregate demand and the UK price level, usually measured in terms of the consumer price index
General Price Level

1. A rise in the general price level from P1 to P2 causes a contraction in aggregate demand 2. A fall in the general price level from P1 to P3 causes an expansion of aggregate demand

P2

P1 P3

AD

Y2

Y1

Y3

Real National Income

Aggregate demand and the price level There are several explanations for an inverse relationship between AD and the price level in an economy. These are summarised below: 1. Falling real incomes: As the price level rises, so the real value of peoples incomes fall and consumers are less able to buy the items they want or need. Imagine that over the course of a year all prices rose by 10 per cent whilst your nominal income remained the same. This would put a squeeze on your real purchasing power. 2. The balance of trade: A high and persistent rise in the price of level of Country X could make foreign-produced goods and services more attractive (cheaper) in price terms, causing a fall in exports and a rise in imports. This will lead to a reduction in net trade (X-M) and a contraction in AD. 3. Interest rate effect: if the price level rises, this causes inflation and an increase in the demand for money and a consequential rise in interest rates with a deflationary effect on the economy. This assumes that the central bank (in our case the Bank of England) is setting interest rates in order to meet a specified inflation target. Shifts in the AD curve A change in the factors affecting any one or more components of aggregate demand i.e. households (C), firms (I), the government (G) or overseas consumers and business (X) changes planned spending and results in a shift in the AD curve. Consider the diagram below which shows an inward shift of AD from AD1 to AD3 and an outward shift of AD from AD1 to AD2. The increase in AD might have been caused for example by a fall in interest rates or an increase in consumers wealth because of rising house prices.

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Price Level

P2

In the short run, shifts in aggregate demand cause fluctuations in the economys output of goods and services.
AD2

P1 P3

AD1

AD3

In the long run, shifts in aggregate demand affect the overall price level but do not affect output.

Y3

Y1

Y2

Real National Income

Short exercise on aggregate demand State whether each factor is likely to increase or decreases the level of aggregate demand for the UK economy (other factors remaining the same). Economic Event Likely impact on aggregate demand (rise / fall / uncertain)

The government decrease the rate of income tax from 22% to 20% There is a 20% fall in average UK house prices over a two year period There is a consumption boom in the countries of the Euro Zone The exchange rate between sterling and the Euro appreciates by 15% (i.e. goes up in value) over the course of a year A new survey finds that business confidence has hit a 5-year low The government announces a 400m plan to build a series of wind farms across the UK Consumers decide to increase their savings ratio Bank of England signals rise in interest rates of % The government increases government spending by 1 billion but raises the amount it takes in income tax by 1 billion

3 4

7 8 9

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10

A Scottish distillery announces that it will now source its bottles from Sweden rather than a bottling manufacturer in the West Midlands Chancellor announces tax exemption scheme on new investments for small to medium sized businesses. Government increase tax burden to highest level for 50 years

11

12

Factors causing a shift in AD

Changes in Expectations Current spending is affected by anticipated future income, profit, and inflation

The expectations of consumers and businesses can have a powerful effect on planned spending. E.g. expected increases in consumer incomes, wealth or company profits encourage households and firms to spend more boosting AD. When confidence turns lower, we see an increase in saving and some companies postpone capital investment projects because of worries over a lack of demand and a fall in the expected rate of profit.

Changes in Monetary Policy i.e. a change in interest

rates
(Note there is more than one interest rate in the economy, although borrowing and savings rates tend to move in the same direction) Changes in Fiscal Policy Fiscal Policy refers to changes in government spending, welfare benefits and taxation, and the amount that the government borrows

An expansionary monetary policy will cause an outward shift of the AD curve. If interest rates fall this lowers the cost of borrowing and the incentive to save, thereby encouraging consumption. Lower interest rates encourage firms to borrow and invest. There are time lags between changes in interest rates and the changes on the components of aggregate demand.

For example, the Government may increase its expenditure e.g. financed by a higher budget deficit - this directly increases AD Income tax affects disposable income e.g. lower rates of income tax raise disposable income and should boost consumption. An increase in transfer payments increases AD particularly if welfare recipients spend a high % of the benefits they receive.

Economic events in the international economy International factors such as the exchange rate and foreign income (e.g. the economic cycle in other countries) A fall in the value of the pound () (a depreciation) makes imports dearer and exports cheaper - the net result should be that UK AD rises the impact depends on the price elasticity of demand for imports and exports and also the elasticity of supply of UK

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exporters in response to an exchange rate depreciation. An increase in overseas incomes raises demand for exports and therefore UK AD rises. In contrast a recession in a major export market will lead to a fall in UK exports and an inward shift of aggregate demand. Changes in household wealth Wealth refers to the value of assets owned by consumers e.g. houses and shares A rise in house prices or the value of shares increases consumers wealth and allow an increase in borrowing to finance consumption increasing AD. In contrast, a fall in the value of share prices or a recession in the housing market ca lead to a decline in household financial wealth and a fall in consumer demand.

Let us look at the components of demand for the UK economy. These are presented in the chart below. Notice first that the data has been adjusted for the effects of inflation; we confirm this because the figures are expressed at constant 2003 prices.

The Components of Aggregate Demand

bn per year at constant 2003 prices
800 800

700

700

600
2003 GBP (billions)

600 Consumer Spending

500 Imports 400

500
billions

400

300 Government spending 200 Investment 100 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04

Exports

300

200

100 05 06 07

Source: Reuters EcoWin

Consumer spending is overwhelmingly the biggest single part of AD. A large and rising share of spending goes on imported goods and services but the UK economy has also managed to achieve a sizeable increase in the real value of our exports. However, the value of imports has exceeded exports leading to a trade deficit. This means that net trade has had the effect of reducing total aggregate demand, in this sense it has acted as a pressure valve taking away some of the excess demand for goods and services in the British economy.

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Key terms Budget deficit Consumption Expectations Exports Government spending Household wealth Imports Investment Net Trade Time lags When the government is spending more than it receives in tax revenue the effect is a rise in aggregate demand Consumer spending on goods and services How we expect the future to unfold this can have powerful effects on the spending decisions of households, businesses and the government Goods and services sold overseas an injection of demand Government provided goods and services and social security payments The value of assets owned by households including property, shares, savings and pension fund assets Goods and services bought from overseas a withdrawal of demand Spending on capital goods including plant & machinery and infrastructure The balance between the value of exports and imports The time it takes for one change e.g. a change in interest rates to affect other variables e.g. consumer confidence and spending

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