Aggregate Demand (AD):
Aggregate demand is the total of all demands or expenditures within the economy at any given price over a given period time. It is therefore a quantitative sum of all the individual demands (quantity that is bought at any given price) within the economy. In economics ‘aggregate’ refers to the ‘total’ or ‘added up amount’.
Aggregate demand is also different from individual demand that it is composed from four different components, which are: consumption (C), investment (I), government spending (G) and exports minus imports (X-M). Hence, it can be represented by the formula:
AD = C I G ( X – M )
Consumption refers to the spending by households on goods and services and may also be cited as consumer spending under some circumstances. The meaning of investment is also very specific in that it refers to the spending by firms on investment goods and is not the general purchase of capital goods within the economy. Government spending also specifically includes current spending for on wages and salaries and the spending by government on investment goods such as new roads, schools and hospitals. The final component is exports less imports as when foreigners spend on domestic goods they add to the national expenditure on the local economy. On the other hand, when the local population spends on foreign goods, this is a withdrawal from the economy and effectively has the effect of reducing the national output, hence not contributing to the national income of the economy. It is important to note that all the three components of consumption, investment, government spending may also include spending on imports, thus these should be taken into account when deducting from the aggregate demand figure.
The components of aggregate demand all have different weightings, as a result, the effect of changes in some components are more significant than the changes in other components. The most significant component is considered to be consumption, as in the UK household spending accounts for over sixty five percent of aggregate demand. This might be because consumer spending is controlled by the general population in the economy which is the largest economic group in the UK. Alternatively, capital investment spending by firms in the UK accounts for 15-20% of GDP in any given year. Most of this investment, at a rate of 75% comes from private sector businesses such as Tesco and British Airways while the rest is due to public sector spending such as spending on the improvement of the healthcare. It should be appreciated that public sector spending falls under business investment and not government spending which is solely on state-provided goods and services, including public and merit goods. Government spending can be considered to be the most variable of aggregate demand as decisions on annual government spending are based the development of the economy and changing political priorities. In an average year the government accounts for about 20% of GDP in the economy. Furthermore, transfer payments in the form of welfare benefits are also don’t fall under government spending.
Nevertheless, aggregate demand can be influenced by a range of factors. One of the most important factors that may affect aggregate demand can be considered to be taxation – both direct and indirect. A decrease in taxation is likely to cause an increase in consumption due to their being higher disposable incomes available to the government. Moreover, the decrease in indirect taxation, such as VAT is likely to make goods cheaper, therefore increasing demand for these goods. A decrease in corporation tax is also likely to cause an increase in business investment as now there are more retained profits that can be put back into the business. An increase in taxation is also likely to increase government revenue, which may lead to an increase in government spending. Thus, overall a decrease in taxation is like to cause an increase in aggregate demand and vice versa.
Interest rates may also have an effect on the levels of aggregate demand in the economy. As interest rates can be considered to be a cost of borrowing a decrease in them is likely to mean it becomes cheaper to borrow, as a result borrowing may be encouraged in the economy. Thus it is likely that business investment is likely to increase along with consumer spending as both businesses and consumers can increase their funds through borrowing. Another factor may be the level of inflation and price stability in the economy over a period of time. Low inflation will mean that there is a lower decrease in the value of savings, hence there might not be a change in disposable incomes, encouraging spending. Also, low inflation means that factors of production are available to businesses at a lower price, which may lead to higher investment by businesses. As a result, both low inflation and interest rates may lead to higher levels of aggregate demand which may also be achieved if there are high levels of availability of credit in the economy as this means that there is an easier access to cash.
The level of marginal propensity to consume and the marginal propensity to save also have an effect on the level of aggregate demand in the economy, with aggregate demand being the highest when there is a high marginal propensity to consume but it is low for savers. This is because it means that less money is withdrawn from the circulation hence leading to a larger multiplier effect which is a knock on effect from an initial economic activity. Nevertheless, there are some factors that are likely to have the largest effect on government expenditure such as political and public pressure, which could force the government to either spend or save. Moreover, a decrease in living standards and under consumption of merit goods may also cause aggregate demand to increase as it can force the government to increase their spending in order to restore living standards.
Aggregate Supply (AS):
There are two types of long run aggregate supply curves. The one on the left is the Monetarist curve which may also be referred to as the classical long run aggregate supply curve. The other type of curve is called the Keynesian supply curve. The Monetarist curve is a vertical straight line showing that supply is inelastic in the long run. This is because it is based on the classical view that markets tend to correct themselves fairly quickly when they are pushed into disequilibrium by some shock. According to such a view all markets are likely to be in equilibrium, hence there are no unemployed resources in the economy as it is operating at full potential. As a result there can be no increase in supply as there are no spare factors of production available, leading to an inelastic long run aggregate supply curve.
However, on the other hand Keynesian economists argue that there have been times when markets have failed to clear for long period of time. Hence, under this view, at an output level of Yf the supply curve is perfectly inelastic as the economy is operating at full capacity. Alternatively, at an output level below Y1 the economy is considered to be in a deep and prolonged depression. Hence at such an output level markets may fail to clear, so firms can hire and fire workers without affecting the wage rate, thus there is no pressure on prices when output expands. At an output level between Y1 and Yf labour is becoming scarce enough for an increase in demand for labour to push up wages which then leads to a higher price level. So, the nearer the output gets to Yf, the greater the demand, hence a greater effect on wages and the price levels within the economy, as illustrated by the curved section in the demand curve.
