A S h a c r o e c o n o mI c s l I n t e r n a t I o n a I E c o n o m y

Aggregate Demand
Ths secton yves you c plct]orm ]or understcndny ssues such cs njlaton economc yrowth cnd
unemloyment. Ayyreycte demcnd (A0) cnd cyyreycte supply (AS) cnclyss provdes c wcy o]
llustrctny mccroeconomc relctonshps cnd the e]]ects o] yovernment polcy chcnyes.
Aggregate 0emand
The IdentIty for calculatIng aggregate demand (A0) Is as follows:
A0 = C + I + C + (X-h)
Where
C: Consumers' expendIture on goods and servIces: ThIs Includes demand for consumer durables
(e.g. washIng machInes, audIovIsual equIpment and motor vehIcles E nondurable goods such as
food and drInks whIch are "consumed" and must be repurchased). Household spendIng accounts
for over sIxty fIve per cent of aggregate demand In the UK.
I: CapItaI Investment - ThIs Is Investment spendIng by companIes on capItaI goods such as new
plant and equIpment and buIldIngs. nvestment also Includes spendIng on workIng capItaI such as
stocks of fInIshed goods and work In progress.
CapItal Investment spendIng In the UK typIcally accounts for between 1520 of C0P In any gIven
year. Df thIs Investment, 75 comes from prIvate sector busInesses such as Tesco, 8rItIsh AIrways
and 8rItIsh Petroleum and the remaInder Is spent by the publIc (government) sector - for example
Investment by the government In buIldIng new schools or Investment In ImprovIng the raIlway or
road networks. So a mobIle phone company such as D2 spendIng f100 mIllIon on extendIng Its
network capacIty and the government allocatIng f15 mIllIon of funds to buIld a new hospItal are
both counted as part of capItal Investment. nvestment has Important longterm effects on the s
suppIy-sIde of the economy as well as beIng an Important although volatIle component of
aggregate demand.
C: Covernment SpendIng - ThIs Is government spendIng on stateprovIded goods and servIces
IncludIng publIc and merIt goods. 0ecIsIons on how much the government wIll spend each year are
affected by developments In the economy and also the changIng polItIcal prIorItIes of the
government. n a normal year, government purchases of goods and servIces accounts for around
twenty per cent of aggregate demand. We wIll return to thIs agaIn when we look at how the
government runs Its fIscal polIcy.
Transfer payments In the form of welfare benefIts (e.g. state pensIons and the jobseekers
allowance) are not Included In general government spendIng because they are not a payment to a
factor of productIon for any output produced. They are sImply a transfer from one group wIthIn the
economy (I.e. people In work payIng Income taxes) to another group (I.e. 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 InternatIonaI trade In goods and servIces
between the UK economy and the rest of the world.
X: Exports of goods and servIces Exports sold overseas are an InfIow of demand (an InjectIon)
Into our cIrcular flow of Income and therefore add to the demand for UK produced output.
h: Imports of goods and servIces. mports are a wIthdrawaI of demand (a leakage) from the
cIrcular flow of Income and spendIng. Coods and servIces come Into the economy for us to consume
and enjoy but there Is a flow of money out of the economy to pay for them.
Net exports (X-h) reflect the net effect of InternatIonal trade on the level of aggregate demand.
When net exports are posItIve, there Is a trade surpIus (addIng to A0); when net exports are
negatIve, there Is a trade defIcIt (reducIng A0). The UK economy has been runnIng a large trade
defIcIt for several years now as has the UnIted States.
Aggregate demand shocks

conomc events such cs chcnyes n nterest rctes cnd economc yrowth n the 0nted Stctes ccn
hcve c power]ul e]]ect on other countres ncludny the 0K. Ths s beccuse the 0SA s the world's
lcryest economy. 15 per cent o] our exports yo to the 0SA.
Lots of unexpected events can happen whIch cause changes In the level of demand, output and
employment In the economy. These unplanned events are called "shocks" Dne of the causes of
fluctuatIons In the level of economIc actIvIty Is the presence of demand-sIde shocks.
Some of the maIn causes of demandsIde shocks are as follows:
O A capItaI Investment boom e.g. a constructIon boom to Increase the supply of new houses
or to buIld new commercIal and IndustrIal buIldIngs.
O A rIse or faII In the exchange rate - affectIng net export demand and havIng followon
effects on output, employment, Incomes and profIts of busInesses lInked to export
IndustrIes.
O 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.
O A large boom In the housIng market or a slump In share prIces.
O An unexpected cut or an unexpected rIse In Interest rates.


The Aggregate 0emand Curve
The A0 curve shows the relatIonshIp between the general prIce level and real C0P.
hy does the A0 curve sIope downwards!
There are several explanatIons for an Inverse relatIonshIp between aggregate demand and the prIce
level In an economy. These are summarIsed below:
O aIIIng reaI Incomes: As the prIce level rIses, so the real value of people's Incomes fall and
consumers are then less able to afford UK produced goods and servIces.
O The baIance of trade: As the prIce level rIses, foreIgnproduced goods and servIces become
more attractIve (cheaper) In prIce terms, causIng a fall In exports and a rIse In Imports.
ThIs wIll lead to a reductIon In trade (X|) and a contractIon In aggregate demand.
O Interest rate effect: If In the UK the prIce level rIses, thIs causes an Increase In the
demand for money and a consequentIal rIse In Interest rates wIth a deflatIonary effect on
the entIre economy. ThIs assumes that the central bank (In our case the 8ank of England) Is
settIng Interest rates In order to meet a specIfIed InflatIon target.
ShIfts In the A0 curve
A change In factors affectIng any one or more components of aggregate demand, households (C),
fIrms (), the government (C) or overseas consumers and busIness (X) changes planned aggregate
demand and results In a shIft In the A0 curve.
ConsIder the dIagram below whIch shows an Inward shIft of A0 from A01 to A0J and an outward
shIft of A0 from A01 to A02. The Increase In A0 mIght have been caused for example by a fall In
Interest rates or an Increase In consumers' wealth because of rIsIng house prIces.
actors causIng a shIft In A0
Changes In ExpectatIons
urrent spendny s c]]ected by
cntcpcted ]uture ncome pro]t
cnd n]lcton
The expectctons o] consumers cnd busnesses can have a powerful effect
on planned spendIng In the economy E.g. expected Increases In consumer
Incomes, wealth or company profIts encourage households and fIrms to
spend more - boostIng A0. SImIlarly, hIgher expected InflatIon encourages
spendIng now before prIce Increases come Into effect a short term boost
to A0.
When confIdence turns lower, we expect to see an Increase In savIng and
some companIes decIdIng to postpone capItal Investment projects because
of worrIes over a lack of demand and a fall In the expected rate of profIt on
Investments.
Changes In honetary PoIIcy - I.e. a
change In Interest rates
(Note there s more thcn one
nterest rcte n the economy
clthouyh borrowny cnd scvnys
rctes tend to move n the scme
drecton)
An expansIonary monetary polIcy wIll cause an outward shIft of the A0
curve. f 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.
Changes In IscaI PoIIcy
sccl Polcy re]ers to chcnyes n
yovernment spendny wel]cre
bene]ts cnd tcxcton cnd the
cmount thct the yovernment
borrows
For example, the Covernment may Increase Its expendIture e.g. fInanced by
a hIgher budget defIcIt, thIs dIrectly Increases A0

ncome tax affects dIsposable Income e.g. lower rates of Income tax raIse
dIsposable Income and should boost consumptIon.
An Increase In transfer payments raIses A0 - partIcularly If welfare
recIpIents spend a hIgh of the benefIts they receIve.
EconomIc events In the
InternatIonaI economy
nternctoncl ]cctors such cs the
exchcnye rcte cnd ]oreyn ncome
(e.y. the economc cycle n other
countres)
A fall In the value of the pound (f) (a deprecIatIon) makes Imports dearer
and exports cheaper thereby dIscouragIng Imports and encouragIng exports -
the net result should be that UK A0 rIses - the Impact depends on the prIce
elastIcIty of demand for Imports and exports and also the elastIcIty of
supply of UK exporters In response to an exchange rate deprecIatIon.
An Increase In overseas Incomes raIses demand for exports and therefore UK
A0 rIses. n contrast a recessIon In a major export market wIll lead to a fall
In UK exports and an Inward shIft of aggregate demand.
The UK Is an open economy, meanIng that a large and rIsIng share of our
natIonal output Is lInked to exports of goods and servIces or Is open to
competItIon from Imports.
Changes In househoId weaIth
eclth re]ers to the vclue o] cssets
owned by consumers e.y. houses
cnd shcres
A rIse In house prIces or the value of shares Increases consumers' wealth
and allow an Increase In borrowIng to fInance consumptIon IncreasIng A0. n
contrast, a fall In the value of share prIces wIll lead to a declIne In
household fInancIal wealth and a fall In consumer demand.