You have already learnt about demand and supply for individual economic agents and markets; aggregate demand and supply is the total amount of demand and supply in an economy.
The Components of Aggregate Demand
Aggregate demand is the total demand in an economy; it is equal to consumption + investment + government spending + exports – imports. We can see how consumption + investment + government spending + exports make up aggregate demand on the diagram below. Imports are taken off the total as they are a withdrawal from the circular flow of income.
We will look at each of the components of aggregate demand in detail later in this chapter.
The Shape of the Aggregate Demand Curve
Aggregate demand increases as the price level falls.
There are a number of explanations for the shape of the curve:
- When the price level falls, customers will feel richer as their income and savings will be able to buy more goods and services than previously. This is known as the wealth effect and will lead to increased consumption at lower price levels (more detail on the wealth effect later in this section).
- A lowering of the price level will improve the competiveness of UK businesses as their goods may become cheaper than the foreign equivalent. Any increases in exports will increase aggregate demand and therefore national income.
- A fall in the price level will often lead to a cut in the rate of interest (see inflation notes). When the interest rate falls, there will be an increase in consumption, investment and exports, all of which add to aggregate demand.
- The level of expectations. If you expected the price to increase in the future, you would be more likely to buy the good now, rather than later on. Conversely, an expected fall in the price level will lead to customers postponing their purchases until the price drops.
Movements Along the Aggregate Demand Curve
Any change in the price level will lead to a movement along the aggregate demand curve.
Shifts in Aggregate Demand
If one of the components of aggregate demand increases or decreases there will be shift in the aggregate demand curve.
The above diagram shows the effects of a shift in aggregate demand. This shows what will happen to national income at a constant price level.
Consumption and Savings
Consumption is responsible for about two thirds of aggregate demand.
Average and Marginal propensity to Consume
The average propensity to consume (APC) is defined as:
Average propensity to consume = Total consumption / Total income
It is expressed as a fraction, for example, if your income is £10,000 and you consume £8,000 then your average propensity to consume is 0.8 (8,000/10,000).
The marginal propensity to consume (MPC) is the change in consumption that results from a change in income, it is defined as:
Marginal propensity to consume = Increase in consumption / Increase in income
Similarly to the APC it is expressed as a fraction, for example, if your income increased by £1,000, and you spent £600 and saved £400, then your marginal propensity to consume would be 0.8 (£600 / £1,000).
Consumers are left with their disposable income once taxes have been paid from their gross income. They are faced with two choices: to consume or to save their disposable income.
The average propensity to save (APS) is the fraction of disposable income that consumers choose to save. The average propensity to save plus the average propensity to consume must equal 1.
Average propensity to save = Total saving / Total income
The marginal propensity to save (MPS) is the change in saving resulting from a change in disposable income.
Marginal propensity to save = Increase in saving / Increase in income
The marginal propensity to save plus the marginal propensity to consume must equal 1.
Consumption and Income
Income and consumption are positively related, in other words, a rise in income will lead to an increase in consumption.
Consumption and the rate of interest
A change in the rate of interest will have a great impact on consumption. The following outlines the effects of a decrease in the rate of interest:
- The effect on saving. Households will be less likely to save their disposable income after a decrease in the rate of interest; this would increase the level of consumption.
- The affect on mortgage repayments. People with variable rate mortgages would have to pay less money every month to their building society/bank; this would increase the level of consumption.
- The effect on loans and credit used by households. People be more likely to take out loans and use credit cards when the interest rate falls; this would increase the level of consumption.
The Wealth Effect and consumption
We already know that consumers will spend more when they are richer; the wealth effect states that people will also increase their consumption when they feel richer. There are a number of factors that could lead people thinking they are richer and the wealth effect occurring: falling price level, increase in the value of housing and a rise in the stock market.
- Price level and the wealth effect – earlier in this chapter we looked at a wealth effect that occurs when the price level falls.
- An increase in house prices will lead to the wealth of home owners rising. When the value of a person’s home is greater than their mortgage, they have positive equity in their home. Financial institutions will often lend money to people using this positive equity as collateral on the loan (you’ve probably heard the term ‘your home is at risk if you don’t keep up the repayments’).
If house prices fall, homeowners could face negative equity; this occurs when the value of a home is less than the mortgage on it. Negative equity will reduce the level of consumption.
- An increase in the value of stocks and shares will contribute to the wealth effect.
Consumer Confidence and Consumption
The level of consumer confidence can greatly impact upon the level of consumption and saving in the economy.
The table below shows the values for the consumer confidence index and the five core measures that make it up. A value of 0 indicates that consumers who are optimistic equals those who are pessimistic, while a negative value indicates those who are pessimistic outweigh those who are positive.
In the chart below the index annual moving average is used to smooth out any fluctuations, thereby making any trends easier to identify.
Source: GfK/NOP consumer confidence press release.
There are many factors that affect the level of consumer confidence, including:
- Interest rates
- Personal financial situation
- Job security
- Expectations of inflation
- Changes to taxation
Investment is the spending by firms on capital goods. Investment increases the productive capability of an economy and will shift the economy’s production possibility boundary outwards.
Investment can only be carried out by businesses; consumers do not ever invest, they save. It is important you remember this distinction between an economist’s definition and the average person in the street.
It is important to distinguish between gross investment and net investment; net investment equals gross investment minus depreciation.
If net investment equalled zero you would expect an economy’s production possibility boundary to remain unchanged.
Factors affecting a firm’s decision to invest
There are a wide range of factors that will affect a business’s decision to invest, the main reasons are:
- The rate of interest – a rise in the rate of interest will reduce the level of investment as the cost of borrowing money will rise.
- Business expectations – these will affect the decision making process of the business.
- The price of capital goods – the price of capital goods could rise for any number of reasons including changes in the exchange rate make imports more expensive, or there could be an increase in the cost of raw materials.
- The level of technology rises.
- The level of consumer spending – see the notes below on the accelerator.
The accelerator theory suggests that investment changes when the demand for goods and services change. An increase in consumption will lead to an increase in business investment. This suggests that investment is a derived demand.
There are a number of limitations to the accelerator model:
- Most firms are more likely to invest and increase their capital stock if they believe that consumption is going to increase in the future rather than simply responding to past increases.
- If businesses believe the increase in consumption to be temporary they will not increase their investment.
- If businesses already have spare capacity then they will not need to invest in order to meet the increase in demand
Why Do Firms Invest?
Would an increase in gross investment only or an increase in both gross and net investment mean that there had been an increase in what the economy is able to produce?
There are a number of main reasons why a business would choose to invest:
- To increase its productive capabilities, thereby increasing the firm’s capacity.
- To take advantage of technological progress and innovation
- To take advantage of economies of scale.
There will be an improvement in the UK’s international competitiveness if firms undertake lots of investment.
The government uses its spending to achieve particular goals; in order to achieve these goals it may spend more than it receives in tax, this is called the Public Sector Net Cash Requirement (PSNCR). See the later chapter called ‘fiscal policies’ for more details on government spending.
Exports and Imports
Exports are goods and services sold to other countries and they are an injection into the circular flow of income. An increase in exports will shift the aggregate demand curve to the right.
Imports occur when the UK purchases goods and services from other countries, they are a withdrawal from the circular flow of income. An increase in exports will shift the aggregate demand curve to the left.
An exchange rate is the price at which one currency is bought and sold for another, for example, if the British Pound and US Dollar’s exchange rate is £1.00 = $2.00 then a £1 coin could be sold for $2.00, or, an American would have to offer $2.00 in order to obtain a £1 coin.
When other countries want goods and services from the UK they will need to purchase pounds in order to buy from UK businesses. This increase in demand for pounds will shift the demand curve to the right and increase the value of the pound.
In order to buy goods and services from abroad we would need to buy the relevant currency; this will involve selling pounds. This will reduce the value of the pound.
Exchange rates and their impact upon exports and imports
We will start our analysis by addressing the impact of an increase in the value of the pound. We are assuming that there are no transport costs and the exchange rate is £1.00 = $2.00.
|If a UK company produced lard bars and sold them for a £1.50. They would be sold for $3.00 in the USA.
|If a US company produced George W Bush masks and sold them for a $10.00. They would be sold for £5.00 in the UK.
Strong UK exports help contribute to the pound getting stronger, its value rises from £1.00 = $2.00 to £1.00 = $2.50. The following table shows what will happen to the prices for the lard bar exports and the George W. Bush mask imports.
The effect of a strong pound has been to make the price of exports more expensive and he price of imports cheaper.
It can be confusing to remember how changes in the exchange affect the price of imports and exports. Thankfully the Spice Girls are on hand to help!
If the pound weakens then the opposite will occur: imports will get dearer and exports become cheaper.
It is important to note how exports and imports will be affected by a change in the exchange rate. After a weakening of the pound the price of exports will go down, however demand for export might not change in quantity much if the demand is relatively inelastic. Price elasticity of demand for exports and imports might be inelastic as individuals and companies might be tied into contracts or they simply may not be aware of the change in price.
This tells us that there is likely to be a time lag between a movement in the exchange rate and the change in volume of exports and imports.
A Spice Girls moment, why not…