Economics (9640) | Determinants of aggregate demand

STUDY NOTES: DETERMINANTS OF AGGREGATE DEMAND (AD)

Welcome to Macroeconomics: The Engine Room of the Economy

Hi there! This chapter is absolutely central to understanding How the Macroeconomy Works. Think of the economy as a massive machine. We are about to look at the fuel that drives that machine: Aggregate Demand (AD).

AD represents all the spending in the economy. If people and businesses spend more, the economy grows; if they spend less, it shrinks. By studying the determinants of AD, you will learn exactly why the economy speeds up or slows down. Don't worry if some terms look intimidating; we will break them down into simple, manageable pieces. Let's get started!

1. Defining Aggregate Demand (AD)

What is Aggregate Demand?

Aggregate Demand (AD) is the total planned expenditure on goods and services in an economy over a given period, at a given price level.

It tells us how much everyone—households, firms, the government, and foreign buyers—is collectively willing to spend.

The Components of Aggregate Demand

AD is made up of four main components. Economists often use a simple formula to remember them:

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

1. C: Consumption (Household Spending)
2. I: Investment (Firm Spending on Capital)
3. G: Government Spending (Public Sector Spending)
4. (X - M): Net Exports (Exports minus Imports)

Key Takeaway: AD is total spending. When any of these four components increases, the entire AD curve shifts right, indicating higher overall spending and output.

2. Determinants of Consumption (C)

Consumption (C) is the largest component of AD, usually making up around two-thirds of total spending. It refers to spending by households on consumer goods and services (like buying food, rent, holidays, and phones).

The amount households spend is determined by several factors:

• Real Disposable Income: This is the income households have left after taxes and including state benefits. If real disposable income rises (e.g., taxes are cut, or wages grow faster than inflation), consumption usually increases.
• Interest Rates:
  • Higher interest rates make borrowing (like mortgages and car loans) more expensive, discouraging spending.
  • Higher rates also increase the reward for saving, making people more likely to save than consume.
  • The opposite is true for lower interest rates.
• Consumer Confidence: If people feel secure about their jobs and believe the economy will improve, they are more willing to spend and take on debt. If confidence is low, they save more (known as precautionary saving).
• Household Wealth: This is the value of a household's assets (houses, stocks, shares) minus their debts. If housing prices or stock markets rise, people feel wealthier and may spend more, even if their income hasn't changed. This is called the wealth effect.
• Social and Emotional Factors: (As per the syllabus) Spending decisions are not purely rational. Social trends (e.g., fashion, environmental awareness) or emotional responses (e.g., panic buying, 'retail therapy') can influence consumption levels.

Analogy: Imagine your favourite football team wins the league (high confidence) and you get a bonus at work (high income). You are more likely to book a fancy holiday (increased C). If the team loses and the central bank raises rates, you stay home and save (decreased C).

3. Determinants of Investment (I)

Investment (I) is spending by firms on capital goods (factories, machinery, software, and new inventory). This is crucial because it increases the economy’s productive capacity in the long run.

Key factors that determine investment:

• Interest Rates: Investment is often financed by borrowing. If interest rates are high, the cost of borrowing increases, making investment projects less profitable.
• Business Confidence / Expectations: Firms invest when they expect future demand and profit to be high. Keynes called these psychological drivers the "animal spirits"—if firms are optimistic, they invest, even if the data isn't perfect.
• Access to Credit: If banks are unwilling or unable to lend money, firms cannot finance new projects, regardless of how profitable they look.
• The Accelerator Process: This concept links current investment levels to the rate of change of national income (or demand). If demand is rising quickly, firms need to invest heavily just to keep up with production. If demand is only rising slowly, less investment is needed.

4. Determinants of Government Spending (G)

Government Spending (G) includes expenditure on public services (healthcare, education, defence) and infrastructure (roads, bridges).

• Fiscal Policy: The government directly controls G. If they want to boost AD (e.g., during a recession), they can increase spending.
• Political and Economic Priorities: Spending is determined by political choices (e.g., a focus on environmental projects or military defence).
• The Budget Position: If the government has a large budget deficit (spending more than it takes in taxes), they may feel pressure to cut G.

5. Determinants of Net Exports (X - M)

Net Exports (X - M) is the difference between money flowing into the economy from selling exports (X) and money flowing out from buying imports (M).

• Exchange Rate:
  • If the domestic currency depreciates (becomes weaker), exports become cheaper for foreigners, and imports become more expensive domestically. X tends to rise, and M tends to fall, increasing Net Exports (AD shifts right).
  • If the currency appreciates (becomes stronger), X falls and M rises, decreasing Net Exports (AD shifts left).
• Real Income Abroad: If the UK's trading partners (like the EU or USA) experience rapid economic growth, their incomes rise, and they buy more UK exports (X rises).
• Real Income at Home: If UK domestic income rises rapidly, UK consumers buy more imported goods (M rises). This often leads to a fall in net exports.
• Relative Inflation Rates: If UK inflation is higher than in competing countries, UK exports become less price competitive, causing X to fall and M to rise (reducing Net Exports).

6. Marginal Propensities and Savings

When income changes, households decide what to do with that change. They can spend it, save it, pay tax on it, or use it to buy imports. These decisions are measured by the Marginal Propensities.

Determinants of Savings

Savings (S) is the portion of disposable income that is not consumed. The determinants of saving are generally the inverse of the determinants of consumption (C).

• Interest Rates: High interest rates reward saving, boosting S.
• Confidence: Low consumer confidence encourages precautionary saving (S rises).
• Income Level: Generally, higher income leads to a higher amount of saving.
• Tax Incentives: Favourable tax treatment on savings accounts boosts S.

The Marginal Propensities

A propensity measures the fraction of an increase in income that is allocated to a particular use.

The key propensities are:

1. Marginal Propensity to Consume (MPC): The fraction of extra income that is spent on consumption.

   $$MPC = \frac{\text{Change in Consumption}}{\text{Change in Income}}$$
   

2. Marginal Propensity to Save (MPS): The fraction of extra income that is saved.

   $$MPS = \frac{\text{Change in Saving}}{\text{Change in Income}}$$
   

3. Marginal Propensity to Tax (MPT): The fraction of extra income paid as tax.
4. Marginal Propensity to Import (MPM): The fraction of extra income spent on imports.

Important Relationship: For any change in income, it must be consumed, saved, taxed, or imported. Therefore, the sum of all marginal propensities must equal one:

$$MPC + MPS + MPT + MPM = 1$$

This relationship is vital for understanding the Multiplier process.

Key Takeaway: The Marginal Propensities show how quickly new income leaks out of the domestic economy (S, T, M). These withdrawals are crucial for the next concept: the Multiplier.

7. Aggregate Demand and the Multiplier Effect

A small initial change in spending can lead to a much larger change in national income. This effect is known as the Multiplier Process.

The Multiplier Process Explained

The multiplier describes why an initial change in expenditure (an injection—I, G, or X) may lead to a larger change in local or national income.

Step-by-Step Example (The Domino Effect):

1. Initial Injection: The Government (G) spends £10m on building a new road (Initial Injection).
2. Round 1: This £10m becomes income for the construction workers and building firms.
3. Leakages (Withdrawals): The workers and firms don't spend all £10m. They save some (MPS), pay tax on some (MPT), and buy imported materials (MPM). The rest they spend (MPC).
4. Round 2: The portion they spend (C) becomes income for others (e.g., local shops and restaurants).
5. Further Rounds: These shopkeepers, in turn, spend a portion of their new income, creating income for a third group, and so on.

Because income is continually re-spent, the final increase in national income is many times greater than the initial £10m injection.

Calculating the Multiplier Value (k)

The value of the multiplier (k) depends on how much income leaks out (the withdrawals/propensities). The formula is:

$$k = \frac{1}{\text{Marginal Propensity to Withdraw (MPW)}}$$

Since MPW is the sum of all leakages (MPS + MPT + MPM), the formula you must be able to calculate is:

$$k = \frac{1}{MPS + MPT + MPM}$$

Alternatively, since \(1 - MPC\) equals the total withdrawal propensity in a closed economy model, we often use the simpler form:

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

The Role of AD in Influencing Economic Activity

The multiplier highlights the significant role of AD (especially injections) in influencing the level of real output and economic activity.

• Large Multiplier: If the marginal propensities to withdraw (MPS, MPT, MPM) are low, the multiplier will be large. This means a small injection can cause a big boom.
• Small Multiplier: If people save, tax, or import most of their extra income, the multiplier is small, and injections have little impact on domestic national income.

Key Takeaway: The multiplier turns a small boost into a big effect. Governments love a high multiplier because it makes fiscal policy very effective, but high leakages (MPS, MPT, MPM) dampen this effect.