Aggregate demand (AD) is the total demand for goods and services produced in the economy over a period of time.

Defining Aggregate Demand

Aggregate planned expenditure for goods and services in the economy =

C + I + G + (X-M)

C Consumers' expenditure on goods and services: This includes demand for durables & non-durable goods.

 I Gross Domestic Fixed Capital Formation - i.e. investment spending by companies on capital goods. Investment also includes spending on working capital such as stocks of finished goods and work in progress.

G General Government Final Consumption. i.e. Government spending on publicly provided goods and services including public and merit goods. Transfer payments in the form of social security benefits (pensions, job-seekers allowance etc.) are not included as they are not a payment to a factor of production for output produced. A substantial increase in government spending would be classified as an expansionary fiscal policy.

X Exports of goods and services - Exports sold overseas are an inflow of demand into the circular flow of income in the economy and add to the demand for UK produced output. When export sales from the UK are healthy, production in exporting industries will increase, adding both to national output and also the incomes of those people who work in these industries.

M Imports of goods and services. Imports are a withdrawal (leakage) from the circular flow of income and spending in the economy. Goods and services come into the economy - but there is a flow of money out of the economic system. Therefore spending on imports is subtracted from the aggregate demand equation.  Note that X-M is the current account of the balance of payments.

We can use a circular flow of income to show the movement of money around an economy.  It is important to distinguish between the injections and withdrawals in the flow.  Factor payments are received from households in return for use of factors of production, individually they are called:

·        Capital – Interest

·        Enterprise – Profit

·        Land – Rent

·        Labour – Wages

The Aggregate Demand Curve

Aggregate demand normally rises as the price level falls. This can be explained in three main ways:

·        Real money balances effect:  As the price level falls, the real value of money balances held increases. This increases the real purchasing power of consumers.

·        Prices and interest rates: A lower price level increases the real interest rate - there will be pressure on the monetary authorities to cut nominal interest rates as the price level falls. Lower nominal interest rates should encourage an increase in consumer demand and planned investment.

·        International competitiveness: If the UK price level is lower than other countries (for a given exchange rate), UK goods and services will become more competitive. A rise in exports adds to aggregate demand and therefore boosts national output.

Shifts In Aggregate Demand

A change in one of the components of aggregate demand will cause a shift in the aggregate demand curve.

An increase in AD (AD₁ ® AD₂) may be caused by:

• An increase in export demand causing an injection of foreign demand into the domestic economy.
• The government may also increase its own expenditure.
• Businesses may raise the level of planned capital investment spending.

A decrease in AD (AD₂ ® AD₁) may be caused by:

• Consumers feeling wealthier and increasing their consumption.
• Businesses are pessimistic about the future of the economy and reduce their level of investment.