IBEconomicsHLRevision Notes3. Macroeconomics 3.2 Variations in Economic Activity (AD & AS)3.2.1 Aggregate Demand (AD)

Aggregate Demand (AD) (HL IB Economics)

Revision Note

Steve Vorster

An Introduction to Aggregate Demand (AD)

  • Aggregate demand (AD) is the total demand for all goods/services in an economy at any given average price level

  • Its value is often calculated using the expenditure approach

    • AD = Consumption (C) + Investment (I) + Government spending (G) + (Exports-Imports) (X-M)

    • AD = C + I + G + (X-M)

  • If AD increases then economic growth has occurred and vice versa

  • Consumption is the total spending on goods/services by consumers (households) in an economy

  • Investment is the total spending on capital goods by firms

  • Government spending is the total spending by the government in the economy:

    • Includes public sector salaries, payments for the provision of merit and public goods etc.

    • It does not include transfer payments

  • Net exports are the difference between the revenue gained from selling goods/services abroad and the expenditure on goods/services from abroad

    • Individuals, firms and governments export/import

The relative importance of the components of AD

  • Depending on the country, the value of each component and its contribution to AD can vary significantly:

    • Government spending in Sweden is 53% of AD and in the UK, it is 25% of AD

  • The % that each component contributes to AD in the UK is approximately

    • Consumption: 60%

    • Investment: 14%

    • Government spending: 25%

    • Net Exports: 1%

  • A 1 % increase in consumption or government spending will have a much larger impact on economic growth than a 1% increase in net exports

The Aggregate Demand (AD) Curve

  • The relationship between the average price level and the total output in an economy is shown with an aggregate demand (AD) curve

2-2-1-aggregate-demand_edexcel-al-economics

The aggregate demand (AD) curve for an economy with Average Price Level on the Y axis and Real GDP on the X axis

  • The AD curve is downward sloping

    • With lower average price levels there is greater aggregate demand

    • With higher average price levels there is less aggregate demand

A Movement Along the Aggregate Demand (AD) Curve

  • Whenever there is a change in the average price level (AP)  in an economy, there is a movement along the aggregate demand (AD) curve

2-2-2-aggregate-demand---movement-along-ad_edexcel-al-economics

An increase or decrease in the average price level (AP) causes a movement along the aggregate demand (AD) curve leading to a contraction or expansion of AD

Diagram Analysis

  • An increase in the AP (ceteris paribus) from AP1 → AP2 leads to a movement along the AD curve from A → B

    • There is a contraction of real GDP from Y1 → Y2

      • Y is the symbol used in macroeconomics to denote national income or real GDP
         

  • A decrease in the AP (ceteris paribus) from AP1 → AP3 leads to a movement along the AD curve from A → C

    • There is an expansion of real GDP (output) from Y1 → Y3

Shifts of the Entire Aggregate Demand (AD) Curve

  • Whenever there is a change in any of the non-price determinants of aggregate demand (AD) in an economy, there is a shift of the entire AD curve
     

2-2-1-aggregate-demand---shift-in-ad_edexcel-al-economics

A shift in the entire aggregate demand (AD) curve occurs when there is a change in one of the determinants of AD

Diagram Analysis

  • An increase in any one of the non-price determinants of aggregate demand (AD) results in a shift right of the entire curve from AD1 → AD2

    • At every price level, real GDP has increased from Y1 → Y2

  • A decrease in any one of the non-price determinants of AD results in a shift left of the entire curve from AD1 → AD3

    • At every price level, real GDP has decreased from Y1 → Y3

Factors that Influence each Component of Aggregate Demand (AD)

  • Each component of AD is influenced by numerous factors

  • A change to any of these factors will potentially change AD

  • Consumption is influenced by changes to consumer confidence, interest rates, wealth, income taxes, level of household indebtedness, and expectations of future price level

  • Investment is influenced by changes to interest rates, business confidence, technology, business taxes, and the level of corporate indebtedness

  • Government spending is influenced by changes to political and economic priorities

  • Net exports are influenced by changes to the income of trading partners, exchange rates, and trade policies
     

Factors that Influence Consumption


Component


Influence on the component


Explanation

Consumption


  • Consumer confidence

  • The stronger the economy, the higher consumer confidence

    • Consumers feel secure in their jobs and are confident of receiving regular salary payments

    • Consumption increases and saving decreases

  • In a weakening or recessionary economy, consumer confidence falls

    • Consumers feel less secure in their jobs

    • Consumption decreases and saving increases

  • Interest rates

  • A change in the base interest rates will change the level of consumer spending and savings

  • If interest rates increase there is a greater incentive to save

    • More saving = less consumption

  • If interest rates increase, the monthly repayment on any loan or mortgage increases

    • Higher loan repayments = less consumption

  • Wealth

  • If consumer wealth increases, then consumption usually increases

  • Rising property prices or share prices give consumers confidence to borrow more money

    • Increased borrowing = increased consumption

  • Income taxes

  • Disposable income is the money that households have left from their salary/wages after they have paid their taxes and have received any transfer payments/benefits

  • If taxes increase, then disposable income decreases - and vice versa

  • Level of household indebtedness

  • Debt is usually repaid with monthly payments

  • The higher the level of debt, the higher the monthly repayment and the less money available for new consumption

  • Expectations of future price level

  • If consumers believe prices will rise in the future, they are incentivised to consume now - and vice versa

 
Factors that Influence Investment


Component


Influence on the component


Explanation

Investment


  • Interest rates

  • Most investment by firms is financed through business loans

  • Decreasing interest rates encourage investment

  • There is a mostly inverse relationship between investment and interest rates

  • Business confidence

  • Firms will choose to invest if they feel confident that they will make a good return on their investment

    • The decision to invest is linked to the business objective of profit maximisation

  • The longer a period of economic growth, the higher the business confidence will be

    • If growth slows, future expectations of profits will decrease and investment decisions become harder

  • Technology

  • When a firm identifies new technology which will reduce costs and raise output, they are incentivised to invest

  • Business taxes

  • When governments raise business taxes it reduces the profits of firms

  • Lower profits mean there is less money available for investment

  • Level of corporate indebtedness

  • Corporate debt is usually repaid with monthly payments

  • The higher the level of debt, the higher the monthly repayment and the less money available for new investment

 
Factors that Influence Government Spending


Component


Influence on the component


Explanation

Government spending


  • Political priorities

  • Governing parties have different political priorities which influence spending

  • Some parties believe the state should provide more goods/services and spending increases

  • Other parties believe the role of government in society should be smaller and spending decreases

  • Economic priorities

  • Fiscal Policy is set once a year and announced during the presentation of the Government's budget

  • Expenditure is directly related to the Government's objectives and policy aims

    • E.g., A policy aimed at upgrading a country's rail network requires increased expenditure

 
Factors that Influence Net Exports


Component


Influence on the component


Explanation

(Exports - Imports)


  • Income of trading partners

  • When the household income of trading partners increases, foreigners purchase more products - exports increase

  • When the household income of trading partners decreases, foreigners purchase fewer products - exports decrease

  • Exchange rates

  • When the domestic currency appreciates, consumers' money goes further abroad - imports increase

  • When the domestic currency appreciates, exports are more expensive for foreigners - exports decrease

  • When the domestic currency depreciates, consumers' money goes less far abroad - imports decrease

  • When the domestic currency depreciates, exports are less expensive for foreigners - exports increase

  • Trade policies

  • If protectionism increases there is decreased demand for imports as they are more expensive

  • If protectionism decreases there is increased demand for imports as they are less expensive - and exports usually increase due to free trade

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Steve Vorster

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