Aggregate Demand (AD)

Aggregate Demand (AD)

• Aggregate demand is the total demand in an economy.
• Aggregate demand measures spending on goods and services by consumers, firms, governments, and overseas entities.
• The formula for aggregate demand is C + I + G + (X - M), where C is consumer spending, I is capital investment, G is government spending, X is exports, and M is imports.

Consumer Spending

• Consumer spending is the amount spent on goods and services.
• It's the largest component of AD, exceeding 60% of GDP.
• As the most significant factor for increasing economic growth, consumer spending is influenced by interest rates.
• When the Monetary Policy Committee lowers interest rates, borrowing becomes cheaper.
  • The incentive to save decreases, which boosts spending and investment.
  • Time lags exist between interest rate changes and the increase in AD.
  • Lower interest rates reduce debt costs, increasing households' disposable income.
• Consumer confidence affects spending and investment.
  • Higher confidence leads to increased investment and spending due to expected higher returns.
  • Reduced confidence due to fears of unemployment or higher taxes leads to decreased spending and more saving.
• Disposable income, the amount left after taxes and social security, is what consumers can spend.
• Consumer income sources includes wages, savings, pensions, benefits, and investments.

Capital Investment

• Capital investments accounts for 15-20% of the UK's GDP annually and is primarily from private sector firms.
• The government accounts for the remaining spending, by investing in new infrastructure like schools.
• It's the smallest component of AD, influenced by:
  • Rate of economic growth.
    • High growth increases firm revenues, leading to more profits available for investment.
  • Business expectations and confidence.
    • Higher expected rates of return encourage investment.
    • Firms need certainty about the future to invest confidently.
    • Investment is impacted by societal and political expectations and less investment occurs during government changes.

Demand for Exports

• The higher the demand, the more likely that firms will invest in exports in anticipation of higher sales.

Interest Rates

• Decreasing interest rates lead to a decrease of the cost of borrowing, leading to investment increases.
• Expectations of consumer spending could lead to investment discouragement due to higher interest rates.

Access to Credit

• Limited access to credit due to banks' unwillingness to lend can hinder firms' investment capabilities.

Government Influence and Regulations

• Corporation tax rates impacts investment with lower rates encouraging investments by allowing firms to retain more profits.

Government Spending

• Government spending, around 18-20% of GDP, is the third largest component of AD.
• It includes state goods and services like the NHS.
• Government expenditures vary based on:
  • Economic growth.
    • Increased government spending aims to stimulate the economy during recessions, increasing the government deficit and needs to be financed.
    • Higher tax revenue during economic growth might lead to decreased government spending as the economy needs no stimulus.
  • Fiscal Policy.
    • The government uses fiscal policy to influence the economy by changing government spending and taxation.
    • Fiscal policy is a demand-side policy, which changes the AD.
    • `Discretionary fiscal policy; implemented through one-off changes.
    • `Expansionary fiscal policy; used during economic declines to boost AD by increasing spending or cutting taxes.
    • `Contractionary fiscal policy; used during economic growth by decreasing expenditure and increasing taxation to reduce the government's budget deficit.

Exports - Imports

• Exports and imports represent the current account value on the balance of payments.
  • Trade surplus is indicated by a positive value, reflecting a net inflow of funds.
  • Trade deficit is indicated by a negative value, reflecting a net outflow of funds.
• The UK suffers from a relatively large trade deficit, which reduces the value of AD.
• It is the second-largest component of AD.
• The main influences on trade balances are:
  • Real income.
    • increased current account deficit during economic growth as consumers consume more, so there is more spending on domestic and imported goods.
    • During economic decline, UK's current account improves as incomes decrease.
  • Exchange rates.
    • Pound depreciation increases import costs and reduces export costs, reducing the current account trade deficit.
    • Demand for UK exports must be price elastic to increase exports.
      • Price inelasticity will devalue exports due to no increase.
  • State of the world economy.
    • Declines in economy falls exports as consumer income declines.
    • Economic downturns in largest export market reduces demand for UK goods and services.
  • Degree of protectionism.
    • Protectionism involves guarding a country's industries from foreign competition through tariffs, quotas, regulation or embargoes.
    • Employing protectionist measures lowers the trade deficit by decreasing imports.
    • Protectionism can decrease exports due to retaliation, which offsets reduced imports.
  • Non-price factors:
    • Country's competitiveness impacts exports based on supply-side policies and innovation, quality, lower labor costs, and better infrastructure.
    • Trade deals and blocs affect a country's exports.

Moving along the AD Curve

• A fall in price from P1 to P2 causes an expansion from Y1 to Y2
• Basic demand laws apply to the AD curve.
• Reasons for downward slope:
  • Higher prices decrease value of real incomes, which makes goods and services become less affordable.
  • High UK inflation makes foreign goods relatively cheap.
  • Higher inflation leads to higher interest rates.
    • Discourages spending as borrowing is more expensive and saving is more attractive.

Shifting the AD Curve

• The AD curve is shifted by changes in the components of AD (C, I, G, or X-M).
• A rise in AD is shown by a shift to the right (AD1→AD2).
• This rise in economic growth occurs when:
  • Consumers and firms have higher confidence levels.
  • The Monetary Policy Committee lowers interest rates.
  • Lower taxation
  • Increase in govt spending - (all factors increasing spending and investment).

Moving along the AS Curve

• The AS curve shows the quantity of real GDP supplied at different price levels.
• The AS curve is upward sloping as producers increase supply at higher price levels in order to achieve higher profits.
• Changes in the price level lead to changes along the AS curve.
• An increase in AD leads to an expansion in the SRAS, from Y1 → Y2, and a fall reduces SRAS from Y1 → Y3.
• Factors affecting SRAS: changes in supply conditions, price levels ans production costs.
  • Higher Price level results in higher profit and higher supply of quantity of real GDP
  • Higher Price level results in the quantity of labour to increase, in order to increase output/supply
  • Higher the wage rates results to firms being less willing in the quantity/supply of labour

SRAS Curve Shifts

• The SRAS curve shifts when conditions of supply changes.
• Price level and production costs mainly determines SRAS.
  • Cost of employment increases supply, which shifts to the left.
  • Stronger exchange rates boost more goods being imported, shifting supply to the right.
  • Government regulation or intervention impacts potential supply from being utilized.
  • Migration decreases potential supply if many workers leaves the country.

LRAS

• In the long run, all factors of production are utilized and output is fixed.

LRAS Changing AD

• Changes in AD only make changes in price levels and not real GDP.

Factors Affecting LRAS

• The LRAS curve is influenced by factors affecting the quantity or quality of production factors with increases in potential output.
• Technological advances shift the LRAS curve to the right when output increases.
  • Changes in relative productivity.
  • Changes in education and skills.
  • Changes in government regulations.
  • Competition policy.

Full Capacity Output

• The economy operates at full capacity when all resources are fully employed.
• The output level is the quantity of goods and services producible when resources are fully employed.
• Operating at full capacity includes low unemployment rates, AD increases, sustainable rates of economic growth.

The Multiplier Effect

• The multiplier effect occurs when new demand leads to increased income in the circular flow, fostering economic growth and job creation.
• Averages incomes, spending boosts, and further income.
• An initial increase in AD leads to greater increases nationally.

Spare Capacity and SRAS Elasticity

• Spare capacity makes SRAS elastic, leading to increased output and a larger multiplier that results from small changes to AD.

SRAS Inelasticity

• SRAS inelasticity means the multiplier effect will be smaller due to prices increasing rather than national income.
• Higher inflation rates lead to higher interest rates, discouraging spending and borrowing while rewarding saving.

Demand-Side Policies

• Policies designed to increase consumer demand, so that total production in the economy increases.

Monetary Policy

• Actions (handled by the Bank of England) used by the government to manage the economy's money flow, influencing interest rates and quantitative easing.
• Monetary policy instruments:
  • Interest Rates: the Monetary Policy Committee alters the interest rates to control the supply of money.
    • The bank controls the base rate which controls the interest rate.
  • Quantitative Easing (QE): the bank buys government bonds and assets which inject money into the economy to promote spending.
    • This has an inflationary effect since it increases the money supply (can also depreciate the currency).

Limitations of Monetary Policy

• Banks might not pass the base rate onto consumers.
• Consumers might be unable to borrow because banks are unwilling to lend.
• Interest rates will be more effective at stimlating the economy when consumer confidence is high.

Fiscal Policy

• Government spending and taxation influence AD conducted by the government.
• Fiscal Policy Instruments:
  • Government Spending and Taxation: governments can change the amount to increase/stimulate the economy.
    • The government increases the circular flow by decreasing taxation.
  • Expansionary Fiscal Policy - aims to increase AD, done by increasing spending or reducing taxation.
  • Deflationary Fiscal Policy - Decreases AD by cutting spending or raising taxes.
    • Improves the government budget deficit.

Direct and Indirect Taxes

• Direct taxes are imposed on income and are paid directly to the government from the tax payer.
  • (e.g. Income, Corporation, NIC, and Inheritance tax.)
• Indirect taxes are imposed on expenditure of goods and services that increases the market price and contracts demand for producers.
  • Ad Valorem - Taxes that are percentages of unit price, such as Value Added Tax (VAT).
  • Specific Taxes - Taxes that are a set per unit fuel duty charge.

Limitations of Fiscal Policy

• Imperfect information can lead to ineficient spending.
• Time lag for fiscal policy to be employed.
• High interest rates may reduce the effectiveness of fiscal policy to increase demand.
• Overspending by the goverment could lead to difficult repayment of debt.

Potential Policy Conflicts and Trade-Offs for Policy Makers

• The Phillips curve implies a short-run trade-off between unemployment and inflation.
• As economic growth increases, unemployment falls, but wages increase and price levels increase.

Supply-Side Policies

• This trade-off can be limited by supply-side policies that reduce structural unemployment without increasing average wages.

Economic Growth V Inflation

• A growing economy is likely to experience inflationary pressures on the average price level.
• A Negative output gap occurs when the actual level of output is less than the potential level of output.
  • This puts downward pressure on inflation by undervaluing all resources.

Positive Output Gap

• A Positive output gap occurs when the actual level of output is greater than the potential level of output.
  • This could be due to resources being used beyond their normal capacity (e.g. labour working overtime). This puts upward pressure on inflation.

Economic Growth V The Current Account

• Higher spending leads to an increase in economic growth.
• Consumers have high marginal propensity to import, likely to be more spending on imports leads to a worsening current account deficit.
• Export-led growth leads to current account surplus with high levels of economic growth.

Economic Growth V The Government Budget Deficit

• Reducing expenditure and increasing tax revenue reduces budget deficit.

Economic Growth V The Environment

• Higher rates of economic growth leads to high levels of negative externalities and the usage of non-renewable resources.

The Issue Governments Face in Managing the Macro-Economy

• Governments face challenges balancing different factors.
  • Environment vs Competitiveness - 'Green taxes' can limit the competitiveness of domestic firms.
  • Progressive taxes vs inflation - taxes limits inequality, but increases inflation.
  • Fiscal vs monetary policy.
  • Interest rate vs inequality.

Government Consequences

• Unintended consequences may occur with goverment policies.
• Raising the minimum wage with the intention of increasing living standards (can make it unaffordable for employers to employ more worker).

Supply-Side Policies

• Policies aim to improve economy's potential with private sector improvements without government intervention and improvements in productivity, innovation and investment.
• Supply-side policies can improve the production possibility.

Market-Based Policies

• Limitations limit the intervention of the government, making the supply and demand policies ineffective.
• Increase incentives with reduced income and corporation, which promotes spending and potential economy growth.
• Promote Competition: -Deregulation/privatization of public sector will improve market efficiency.
• Reform the Labour Market: -Reduces NMW and allocates wages to free market forces, increasing the mobility of worker and economy efficiency.

Interventionist Policies

• Rely on government intervening in the market.
• Promote Competition: stricter goverment and competitve policy to ensure monopoly power is reduced within smaller firms
• Reform the Labour Market: -Improve geographical mobility of labour by improving jab vacancy information.
• Improve Quality of Labour: -Subsidies for training/educations could lowers firm's costs. -Increases healthcare will improve contribution and productivy of workforce.
• Improve Infrastructure: -Spend more on infrastructure by improving and maintaining roads/schools.

AD/AS Graphs

• Both diagrams show effects of employing supply-side policies.
• The LRAS curve shifts to the right and lowers the averages of prices from Y1 to Y2, and an increases in national output.
• Diagram shows keynesian curve.

The Impact of Macroeconomic Policies

• When governments employ a policy, there could be unintended consequences stemming from consumer reactions.
• Raising the minimum wage could make it unaffordable for employers to keep more workers.