Economics (9640) | Aggregate demand and the level of economic activity

Comprehensive Study Notes: Aggregate Demand and the Level of Economic Activity (9640 Economics)

Hello! Welcome to the macroeconomic world of Aggregate Demand (AD). This chapter is essential because it explains what drives the whole economy—it’s the engine that determines how much a country produces and whether people have jobs. Understanding AD is the key to understanding economic fluctuations, from booms to recessions. Let’s dive in!

What is Aggregate Demand (AD)?

In simple terms, Aggregate Demand (AD) is the total planned spending on all goods and services produced in an economy over a given period, at a given price level.

Don't confuse this with microeconomic demand! Micro demand is about one specific product (like demand for coffee). AD is the total demand for everything in the entire country.

The AD Curve: Price Level vs. Output

The AD curve slopes downwards, just like a normal demand curve. But why? When the overall price level (P) in the economy falls, the total demand for goods (Real National Output, Y) increases. There are three main reasons for this inverse relationship:

1. The Wealth Effect: If prices fall, the real value of your existing money and assets (like savings) increases. You feel richer, so you spend more.
2. The Interest Rate Effect: If the price level falls, people need less money to buy goods. This reduces the demand for money, lowering interest rates. Lower interest rates encourage more borrowing and investment, thus increasing AD.
3. The Trade (Net Exports) Effect: If domestic prices fall while foreign prices stay the same, our goods become relatively cheaper overseas. This boosts exports (X) and reduces imports (M), increasing Net Exports (X-M), and therefore increasing AD.

The Components of Aggregate Demand

AD is calculated using four essential components of spending. If any of these increase, AD shifts to the right (increases). If any decrease, AD shifts to the left (decreases).

The formula for AD is:
\(AD = C + I + G + (X - M)\)

1. C: Consumption
   This is the spending by households (consumers) on goods and services, such as buying groceries, paying for haircuts, or purchasing a new car. It is usually the largest component of AD.
2. I: Investment
   This is spending by firms on capital goods (like new factories, machinery, or technology) and sometimes includes housing construction. Crucially, this is NOT financial investment (like buying shares), but spending that increases the productive capacity of the economy.
3. G: Government Spending
   This is spending by the state on public services (like schools, hospitals, defense) and infrastructure (like roads and railways). Note: Transfer payments (like unemployment benefits) are not included here because they don't represent a demand for new output.
4. (X - M): Net Exports
   This is the value of Exports (X) minus the value of Imports (M). Exports are goods sold to foreigners (an injection of demand), and imports are goods bought from foreigners (a leakage of demand).

Did you know? If a country imports more than it exports, (X - M) will be negative, acting as a drag on AD.

Determinants of the Components of AD (Why AD Shifts)

These are the non-price factors that cause the entire AD curve to shift (left or right).

Determinants of Consumption (C) and Savings (S)

• Income: Higher income generally means higher consumption, though consumption is driven by disposable income (after tax).
• Interest Rates: If the central bank raises interest rates, borrowing becomes more expensive (e.g., mortgage costs rise), and saving becomes more attractive. This usually decreases C and increases S.
• Consumer Confidence: If people feel secure about their future jobs and income, they are more likely to spend now (higher C, lower S).
• Wealth Effects: If asset prices rise (e.g., house prices or stock markets), people feel wealthier and spend more, even if their income hasn't changed.

Determinants of Investment (I)

• Interest Rates: Investment often relies on borrowing. If interest rates are high, the cost of borrowing rises, reducing the profitability of new projects, so I falls.
• Business Confidence (‘Animal Spirits’): If businesses feel optimistic about future demand, they invest more now to prepare for increased output.
• Technology: New technology often requires new investment (e.g., buying new, faster machines).
• The Basic Accelerator Process: This concept suggests that investment levels are related to the rate of change of national income. If income growth speeds up, firms may invest heavily to keep up with demand. (Note: You are not required to calculate this, just understand the basic relationship.)

Determinants of Government Spending (G) and Net Exports (X-M)

• Government Spending (G): Primarily determined by political priorities and policy decisions (e.g., a government might increase G to fund green infrastructure or cut G to reduce debt).
• Exchange Rates:
  • If the domestic currency appreciates (gets stronger), our exports are more expensive for foreigners, and imports are cheaper for us. Net Exports (X-M) fall.
  • If the domestic currency depreciates (gets weaker), exports are cheaper, and imports are more expensive. Net Exports (X-M) rise.
• Real Income Abroad: If key trading partners experience economic growth, they will buy more of our exports (X), increasing our AD.
• Real Income at Home: If the domestic economy grows, we buy more imports (M), decreasing Net Exports (X-M).

The Marginal Propensities and Leakages

When someone receives extra income, they don't spend it all. They split it between consuming, saving, paying tax, and buying imports. These are known as the marginal propensities (or ‘proportions’).

The total withdrawals (or leakages) from the circular flow are S (Saving), T (Taxation), and M (Imports).

• Marginal Propensity to Consume (MPC): The proportion of extra income that is spent on consumption.
  Example: If MPC is 0.8, for every $1 extra earned, 80 cents is spent.
• Marginal Propensity to Save (MPS): The proportion of extra income that is saved.
• Marginal Propensity to Tax (MPT): The proportion of extra income taken by the government as tax.
• Marginal Propensity to Import (MPM): The proportion of extra income spent on imports.

Important relationship: The sum of all propensities must equal 1.

\(MPC + MPS + MPT + MPM = 1\)

The sum of the propensities to withdraw is:

\(MPW = MPS + MPT + MPM\)

Aggregate Demand and the Multiplier Effect (3.2.2.4)

The Role of AD in Economic Activity

The level of AD is crucial because it determines the total amount of goods and services demanded, which in turn determines:

• The overall level of Real National Output (Y) and thus GDP.
• The demand for labour, affecting the level of unemployment (specifically demand-deficient or cyclical unemployment).
• The overall price level (inflation).

The Multiplier Process

The Multiplier is the process by which an initial change in component of AD (C, I, G, or X-M) leads to a proportionately larger final change in the level of national income.

Analogy: The Leaky Bucket
Imagine dropping a large stone (the initial investment) into a pond (the economy). The ripples spread out, getting smaller each time. The ‘leakages’ (S, T, M) are what stop the ripples from lasting forever.

1. The government spends £100m on building a new road (Initial Injection, I).
2. The construction workers receive this £100m as income.
3. They immediately spend a proportion of this income (MPC). If MPC = 0.8, they spend £80m, and save/tax/import the rest (£20m withdrawal).
4. The £80m becomes income for the shops and businesses they spent it at.
5. These shops and businesses, in turn, spend 0.8 of the £80m (which is £64m).
6. This process continues until the injection has fully leaked out of the circular flow.

Because of this chain reaction, the final increase in national income (ΔY) is much greater than the initial injection (ΔJ).

Calculating the Value of the Multiplier (k)

Students should be able to calculate the value of the multiplier. The multiplier (k) is defined as:

\(k = \frac{1}{(1-MPC)}\)

Since \((1-MPC)\) is equal to the marginal propensity to withdraw (MPW):

\(k = \frac{1}{MPW}\) or \(k = \frac{1}{MPS+MPT+MPM}\)

Step-by-Step Calculation Example:

Suppose the MPC = 0.75. An economy receives a £5 billion injection of government spending.

1. Calculate the Multiplier (k):
   \(k = \frac{1}{(1-0.75)} = \frac{1}{0.25} = 4\)
2. Calculate the Total Change in National Income (ΔY):
   Total Change = Multiplier \(\times\) Initial Injection
   ΔY = 4 \(\times\) £5 billion = £20 billion

A £5 billion injection led to a £20 billion rise in national income!

Factors Affecting the Multiplier’s Size

The size of the multiplier depends entirely on the leakages (MPW). To get a larger multiplier:

• We need a high MPC (people spend most of the extra income).
• We need a low MPW (low MPS, MPT, and MPM).

If the country has high taxes (high MPT) or imports a lot of goods (high MPM), a large chunk of the new income leaves the domestic circular flow quickly. This results in a smaller multiplier effect.