Aggregate demand (AD) = total spending on goods and services

The formula for calculating aggregate demand is as follows:

AD = C + I + G + (X-M)

The components of aggregate demand (AD)

C: Consumers' expenditure on goods and services: Also known as consumption, this includes demand for durables e.g. audio-visual equipment and vehicles & non-durable goods such as food and drinks which are “consumed” and must be re-purchased.

I: Capital Investment – This is spending on capital goods such as plant and equipment and new buildings to produce more consumer goods in the future. Investment includes spending on working capital such as stocks of finished and semi-finished goods.

Capital investment spending in the UK accounts for between 15-20% 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 building new schools or in improving rail or road networks. Investment has important effects on the supply-side as well as being an important component of AD.

A small part of investment spending is the change in the value of stocks. Producers may find either than demand is running higher than output (i.e. stocks will fall) or that demand is weaker than expected and below current output (in which case the value of 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 amount goes on welfare state payments.

Transfer payments in the form of benefits (e.g. state pensions and the job-seekers allowance) are not included in current government spending because they are a transfer from one group (i.e. people paying income taxes) to another (i.e. pensioners drawing their state pension having retired, or families on low incomes).

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.

Shocks to aggregate demand

• Many unexpected events cause changes in the level of demand, output and employment
• These events are called “shocks”. Some of the causes of AD shocks are as follows:

1. A large rise or fall in the exchange rate – affecting export demand and second-round effects on output, employment, incomes and profits of businesses linked to export industries.
2. A recession in main trading partners affecting demand for exports of goods and services.
3. A slump in the housing market or a big change in share prices
4. An event such as the credit crunch (global financial crisis) – involving a fall in the amount of credit available for borrowing by households and businesses.
5. An unexpected cut or an unexpected rise in interest rates or change in government taxation and spending – for example deep cuts in government spending as part of fiscal austerity

These shocks will bring about a shift in the aggregate demand curve

The Aggregate Demand Curve

The AD curve shows the relationship between the general price level and real GDP

Aggregate Demand and the Price Level

There are several explanations for an inverse relationship between AD and the price level in an economy:

1.Falling real incomes: As the price level rises, the real value of people’s incomes fall and consumers are less able to buy the items they want or need. If over the course of a year all prices rose by 10 per cent whilst your money income remained the same, your real income would have fallen by 10%

2.The balance of trade: A persistent rise in the price of level of Country X could make foreign-produced goods and services cheaper in price terms, causing a fall in exports and a rise in imports. This will lead to a reduction in net trade 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 possible 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.

Factors causing a shift in aggregate demand