What is Aggregate Demand?

Aggregate Demand (AD) measures the total demand of all goods and services (output) in an economy. It represents the Real GDP of all buyers at different price levels, cetrius paribus. Unlike in Microeconomics, where demand in the market came from consumers of a good, the components of Aggregate demand include all expenditure within an economy. It is for these reasons, the components of AD are also the components used in the Expenditure Approach to measuring GDP. 

Consumption (C) - the total demand from consumers

Investment (I) - the total demand from firms investing in Factors of Production

Government Spending (G) - the total demand from Governments

Net Exports (X-M) - the total demand of exports (from other countries) minus the total demand for imports (from within the country).

Interest Rate Effect

An increase in the average price levels represents inflation. When an economy is experiencing higher average price levels (higher increases in inflation) the central bank (whose job it is to control interest rates and usually keep inflation stable) tends to set interest rates higher to encourage savings. A higher interest rate leads to higher savings (a leakage to the circular flow), therefore leading to lower levels of Real GDP.  

On the other hand, lower average prices in an economy tend to lead to lower interest rates and stable borrowing (as lower interest rates mean a lower cost of borrowing from banks) and therefore this will lead to higher overall levels of AD and higher Real GDP. 

We will study this more in the section on Monetary Policy. 

International Trade Effect

Free trade leads to lower prices, as it allows for goods and services to be imported from those who have a lower cost of production and therefore for lower prices. On the other hand, protectionism measures, such as tariffs and Quotas lead to higher prices of imported goods and services (a tariff is a tax on imports and a quota is a limit to the quantity of goods imported). Therefore, when countries engage in free trade, this can lead to overall lower prices within an economy, which can lead to higher overall levels of aggregate demand and therefore higher Real GDP. On the other hand, high levels of protectionism can lead to higher average prices and therefore lower overall levels of Aggregate Demand and therefore a lower Real GDP. 

Changes in Consumption

Disposable Income and Its Influence on Consumer Spending

Disposable income refers to the income available to households after taxes and other mandatory deductions have been accounted for. It represents the funds individuals can use for consumption and saving. Generally, as disposable income rises, consumer spending increases because households have more money to purchase goods and services. However, the extent of this increase depends on various factors, including consumer confidence and economic conditions.

The marginal propensity to consume (MPC) measures the proportion of additional income that households spend rather than save. A higher MPC suggests that a greater share of extra income is directed towards consumption, whereas a lower MPC indicates a preference for saving.

The Relationship Between Savings and Consumption

Savings and consumption are closely linked, as income is either spent or saved. The marginal propensity to save (MPS) represents the fraction of additional income that is saved rather than spent. Since disposable income is allocated between consumption and saving, an increase in savings generally results in lower immediate consumption. However, higher savings can lead to increased investment and future spending, stimulating economic growth in the long run.

The consumption function illustrates the relationship between consumption and income, showing how higher income leads to increased spending while a portion is also saved. Economic theories, such as Keynesian economics, highlight the importance of consumer spending as a driver of economic activity.

Changes in Investment

Distinction Between Gross and Net Investment

Investment refers to spending by businesses on capital goods such as machinery, infrastructure, and technology to enhance productive capacity. There are two key types of investment:

• Gross Investment: This is the total amount spent on new capital goods before accounting for depreciation. It represents the overall increase in capital stock within an economy.

• Net Investment: This is derived by subtracting depreciation (the wear and tear of capital assets) from gross investment. A positive net investment means the economy’s productive capacity is increasing, while a negative net investment suggests that capital stock is shrinking.

Influences on Investment

Investment decisions by businesses are influenced by several economic factors:

• Keynes and ‘Animal Spirits’: Economist John Maynard Keynes introduced the concept of ‘animal spirits’ to describe the psychological and emotional factors that influence business confidence and investment decisions. Even in favourable economic conditions, pessimism or uncertainty can lead to reduced investment.

• Access to Credit: The availability of credit from banks and financial institutions affects investment levels. When credit is easily accessible, firms are more likely to finance expansion. However, credit restrictions can limit investment opportunities.