What is aggregate

demand?

AGGREGATE DEMAND TUTOR2U.NET/ECONOMICS

 Aggregate Demand (AD)

Aggregate Demand (AD) = total

planned real expenditure on a
country’s goods and services
produced within an economy in each
time period.

AGGREGATE DEMAND TUTOR2U.NET/ECONOMICS

 What are the
components of
aggregate demand?

AGGREGATE DEMAND TUTOR2U.NET/ECONOMICS

 Components of Aggregate Demand

The components of aggregate demand are:

• Household spending on goods and services (C)

AGGREGATE DEMAND TUTOR2U.NET/ECONOMICS

 Components of Aggregate Demand

The components of aggregate demand are:

• Household spending on goods and services (C)
• Gross Fixed Capital Investment Spending and
the Value of the Change in Stocks (I)

AGGREGATE DEMAND TUTOR2U.NET/ECONOMICS

 Components of Aggregate Demand

The components of aggregate demand are:

• Household spending on goods and services (C)
• Gross Fixed Capital Investment Spending and
the Value of the Change in Stocks (I)
• Government Spending on Public Services (G)

AGGREGATE DEMAND TUTOR2U.NET/ECONOMICS

 Components of Aggregate Demand

The components of aggregate demand are:

• Household spending on goods and services (C)
• Gross Fixed Capital Investment Spending and
the Value of the Change in Stocks (I)
• Government Spending on Public Services (G)
• Exports of Goods and Services (X)

AGGREGATE DEMAND TUTOR2U.NET/ECONOMICS

 Components of Aggregate Demand

The components of aggregate demand are:

• Household spending on goods and services (C)
• Gross Fixed Capital Investment Spending and
the Value of the Change in Stocks (I)
• Government Spending on Public Services (G)
• Exports of Goods and Services (X)
• (minus) Imports of Goods and Services (M)

AGGREGATE DEMAND TUTOR2U.NET/ECONOMICS

 Components of Aggregate Demand

The components of aggregate demand are:

Spending on • Household spending on goods and services (C)
imports is a minus • Gross Fixed Capital Investment Spending and
because imports the Value of the Change in Stocks (I)
are a leakage /
withdrawal from
• Government Spending on Public Services (G)
the circular flow of • Exports of Goods and Services (X)
income. • (minus) Imports of Goods and Services (M)

AGGREGATE DEMAND TUTOR2U.NET/ECONOMICS

 What is the formula for
calculating aggregate
demand?

AGGREGATE DEMAND TUTOR2U.NET/ECONOMICS

 Formula for Aggregate Demand

The formula for aggregate demand is

expressed as: AD = C+I+G+(X-M)

AGGREGATE DEMAND TUTOR2U.NET/ECONOMICS

 Formula for Aggregate Demand

The formula for aggregate demand is

expressed as: AD = C+I+G+(X-M)
Where:
C+I+G = domestic demand

AGGREGATE DEMAND TUTOR2U.NET/ECONOMICS

 Formula for Aggregate Demand

The formula for aggregate demand is

expressed as: AD = C+I+G+(X-M)
Where:
C+I+G = domestic demand
(X-M) = net exports (trade balance)

AGGREGATE DEMAND TUTOR2U.NET/ECONOMICS

 Formula for Aggregate Demand

The formula for aggregate demand is

Spending on
imports is a minus
expressed as: AD = C+I+G+(X-M)
because imports Where:
are a leakage /
withdrawal from C+I+G = domestic demand
the circular flow of
income.
(X-M) = net exports (trade balance)

AGGREGATE DEMAND TUTOR2U.NET/ECONOMICS

 The Aggregate Demand Curve

The aggregate demand curve shows

a relationship between aggregate
demand and the general price level.

AGGREGATE DEMAND TUTOR2U.NET/ECONOMICS

 THE AGGREGATE DEMAND CURVE
General Price
Level (GPL)

Real GDP (Y)

 THE AGGREGATE DEMAND CURVE
General Price
Level (GPL)

AD = C+I+G+(X-M)

Real GDP (Y)

 THE AGGREGATE DEMAND CURVE
General Price
Level (GPL)

GPL1

AD = C+I+G+(X-M)

Y1 Real GDP (Y)

 THE AGGREGATE DEMAND CURVE
General Price
Level (GPL)

GPL1

GPL2

AD = C+I+G+(X-M)

Y1 Y2 Real GDP (Y)

 THE AGGREGATE DEMAND CURVE
General Price
Level (GPL)

GPL1 Fall in the general price level

causes an expansion of AD

GPL2

AD = C+I+G+(X-M)

Y1 Y2 Real GDP (Y)

 THE AGGREGATE DEMAND CURVE
General Price
Level (GPL)
GPL3

GPL1 Fall in the general price level

causes an expansion of AD

GPL2

AD = C+I+G+(X-M)

Y3 Y1 Y2 Real GDP (Y)

 THE AGGREGATE DEMAND CURVE
General Price
Level (GPL)
GPL3 Rise in the general price level
causes a contraction of AD

GPL1 Fall in the general price level

causes an expansion of AD

GPL2

AD = C+I+G+(X-M)

Y3 Y1 Y2 Real GDP (Y)

 Why does the
aggregate demand
curve slope downwards
from left to right?

AGGREGATE DEMAND TUTOR2U.NET/ECONOMICS

 EXPLAINING THE DOWNWARD-SLOPING AD CURVE

 Real income effect: As the price level falls, the real value of income rises, and
consumers can buy more of what they want or need – this is known as the real
money balance effect

AGGREGATE DEMAND TUTOR2U.NET/ECONOMICS

 EXPLAINING THE DOWNWARD-SLOPING AD CURVE

 Real income effect: As the price level falls, the real value of income rises, and
consumers can buy more of what they want or need – this is known as the real
money balance effect
 Balance of trade effect: A fall in the relative price of level of Country X could make
foreign-produced goods and services more expensive, causing a rise in exports and a
fall in imports. Exports are an injection, imports a withdrawal.

AGGREGATE DEMAND TUTOR2U.NET/ECONOMICS

 EXPLAINING THE DOWNWARD-SLOPING AD CURVE
 Real income effect: As the price level falls, the real value of income rises, and
consumers can buy more of what they want or need – this is known as the real
money balance effect
 Balance of trade effect: A fall in the relative price of level of Country X could make
foreign-produced goods and services more expensive, causing a rise in exports and a
fall in imports. Exports are an injection, imports a withdrawal.
 Interest rate effect: If price inflation is low and this might lead to a reduction in
interest rates if the central bank has a given inflation target. Lower interest rates
means there is less incentive to save and a fall in interest rates may cause the
exchange rate to depreciate and improve exports.

AGGREGATE DEMAND TUTOR2U.NET/ECONOMICS

 SHIFTS IN THE AGGREGATE DEMAND CURVE
General Price Key exam point: Shifts in
Level (GPL) the aggregate demand
GPL3 curve are caused by
factors independent of
changes in the general
GPL1 price level.

GPL2

AD1

Y3 Y1 Y2 Real GDP (Y)

OUTWARD SHIFT IN THE AGGREGATE DEMAND CURVE
General Price
Level (GPL)
GPL3

GPL1

GPL2

AD2
AD1

Y3 Y1 Y2 Real GDP (Y)

OUTWARD SHIFT IN THE AGGREGATE DEMAND CURVE
General Price
Level (GPL)
GPL3

GPL1

GPL2

AD2
AD1

Y3 Y1 Y2 Y4 Real GDP (Y)

OUTWARD SHIFT IN THE AGGREGATE DEMAND CURVE
General Price
Level (GPL) Outward shift of AD means a
GPL3 higher level of demand at
each price level. One or
more of the components of
GPL1 AD must have changed. AD1
shifts to AD2.

GPL2

AD2
AD1

Y3 Y1 Y2 Y4 Real GDP (Y)

INWARD SHIFT IN THE AGGREGATE DEMAND CURVE
General Price
Level (GPL) Outward shift of AD means a
GPL3 higher level of demand at
each price level. One or
more of the components of
GPL1 AD must have changed. AD1
shifts to AD2.

GPL2

AD2

AD3 AD1

Y3 Y1 Y2 Y4 Real GDP (Y)

INWARD SHIFT IN THE AGGREGATE DEMAND CURVE
General Price
Level (GPL) Inward shift of AD means
GPL3 that total expenditure on
goods and services at each
price level has fallen. AD1
GPL1 shifts to AD3.

GPL2

AD2

AD3 AD1

Y5 Y3 Y1 Y2 Y4 Real GDP (Y)

 What are the main
causes of shifts in the
level of aggregate
demand?

AGGREGATE DEMAND TUTOR2U.NET/ECONOMICS

 MAIN CAUSES OF SHIFTS IN AGGREGATE DEMAND

 Changes in real incomes and employment

 Changes in government spending, taxation and borrowing
 Changes in monetary policy interest rates and the supply of credit
 Changes in the external value of a country’s exchange rate
 Changes in the rate of economic growth of trading partner nations
 Fluctuations in consumer and business confidence

AGGREGATE DEMAND TUTOR2U.NET/ECONOMICS

Explain how lower interest rates can increase aggregate demand

A fall in interest rates on

a property mortgage
means that home-
buyers have less to pay
each month paying the
interest on a home loan.
Explain how lower interest rates can increase aggregate demand

A fall in interest rates on This means they have a

a property mortgage
means that home-
buyers have less to pay
each month paying the
interest on a home loan.
higher effective
disposable income
which can be spent on
goods and services.
Explain how lower interest rates can increase aggregate demand

A fall in interest rates on
a property mortgage
means that home-
buyers have less to pay
each month paying the
interest on a home loan.
This means they have a Another effect of lower
higher effective interest rates is usually
disposable income to lower the cost of
which can be spent on servicing a credit card or
goods and services. other types of
borrowing.
Explain how lower interest rates can increase aggregate demand
A fall in interest rates on
a property mortgage
means that home-
buyers have less to pay
each month paying the
interest on a home loan.
This means they have a Another effect of lower
higher effective interest rates is usually
disposable income to lower the cost of
which can be spent on servicing a credit card or
goods and services. other types of
borrowing.
And it also reduces the
incentive to save,
especially if nominal
interest rates on savings
are below the rate of
inflation.
Explain how lower interest rates can increase aggregate demand
A fall in interest rates on
a property mortgage
means that home-
buyers have less to pay
each month paying the
interest on a home loan.
This means they have a Another effect of lower
higher effective interest rates is usually
disposable income to lower the cost of
which can be spent on servicing a credit card or
goods and services. other types of
borrowing.
Through these channels, And it also reduces the
lower interest rates can incentive to save,
be expected to lift especially if nominal
consumer demand interest rates on savings
which is the largest are below the rate of
component of AD. inflation.
Explain how lower interest rates can increase aggregate demand
A fall in interest rates on
a property mortgage
means that home-
buyers have less to pay
each month paying the
interest on a home loan.
Cheaper loans might
also lead to a rise in
planned capital
investment spending by
businesses which is also
a component part of AD.
This means they have a Another effect of lower
higher effective interest rates is usually
disposable income to lower the cost of
which can be spent on servicing a credit card or
goods and services. other types of
borrowing.
Through these channels, And it also reduces the
lower interest rates can incentive to save,
be expected to lift especially if nominal
consumer demand interest rates on savings
which is the largest are below the rate of
component of AD. inflation.
Explain how a fall in state welfare
spending reduces AD
 Household Benefit Cap

The benefit cap was introduced in 2013. It limits

the maximum amount in benefits a household
can receive. For a family or lone parent, the
benefit cap is £23,000 in London and £20,000
elsewhere in the UK. Two of the stated aims of a
benefit cap are (i) To reduce spending on benefits
and encourage positive behavioural changes and
ii) To encourage more people into work.

AGGREGATE DEMAND TUTOR2U.NET/ECONOMICS

Explain how a fall in state welfare spending reduces AD
Two examples of state
welfare transfers are
universal credit (paid to
families on low incomes)
and the state pension
paid to the retired.
Explain how a fall in state welfare spending reduces AD
Two examples of state If the government cuts
welfare transfers are entitlement to welfare
universal credit (paid to transfers, this will have a
families on low incomes) direct impact on the
and the state pension disposable income of
paid to the retired. millions of households.
Explain how a fall in state welfare spending reduces AD
Two examples of state If the government cuts As a result, if disposable
welfare transfers are entitlement to welfare income drops, people
universal credit (paid to transfers, this will have a will have less
families on low incomes) direct impact on the discretionary income to
and the state pension disposable income of spend after essential
paid to the retired. millions of households. bills have been paid.
Explain how a fall in state welfare spending reduces AD
Two examples of state If the government cuts As a result, if disposable
welfare transfers are entitlement to welfare income drops, people
universal credit (paid to transfers, this will have a will have less
families on low incomes) direct impact on the discretionary income to
and the state pension disposable income of spend after essential
paid to the retired. millions of households. bills have been paid.

This will lead to a fall in

consumer spending
which is the biggest
single component of
aggregate demand in
the UK economy.
Explain how a fall in state welfare spending reduces AD
Two examples of state If the government cuts
welfare transfers are entitlement to welfare
universal credit (paid to transfers, this will have a
families on low incomes) direct impact on the
and the state pension disposable income of
paid to the retired. millions of households.
Many low-income
families have very
limited savings to draw
on if their welfare
payments are cut.
As a result, if disposable
income drops, people
will have less
discretionary income to
spend after essential
bills have been paid.
This will lead to a fall in
consumer spending
which is the biggest
single component of
aggregate demand in
the UK economy.
Explain how a fall in state welfare spending reduces AD
Two examples of state If the government cuts As a result, if disposable
welfare transfers are entitlement to welfare income drops, people
universal credit (paid to transfers, this will have a will have less
families on low incomes) direct impact on the discretionary income to
and the state pension disposable income of spend after essential
paid to the retired. millions of households. bills have been paid.

And if they choose to Many low-income This will lead to a fall in

take out loans to families have very consumer spending
maintain spending, they limited savings to draw which is the biggest
risk paying very high on if their welfare single component of
interest rates on payments are cut. aggregate demand in
unsecured loans. the UK economy.
Explain how a drop in business
confidence can affect AD
 Business Confidence

Business confidence describes the forward-

looking expectations of firms. Keynes coined the
term “animal spirits” to describe fluctuating
confidence / pessimism of investors and
businesses. Business confidence usually
measured by survey. Firms are asked about their
expectations for the next 6-12 months.

AGGREGATE DEMAND TUTOR2U.NET/ECONOMICS

Explain how a drop in business confidence can affect AD
Business confidence
reflects expectations
about future sales,
revenues, costs and
profits. Keynes labelled
these “animal spirits.”
Explain how a drop in business confidence can affect AD
Business confidence A drop in business
reflects expectations confidence might be
about future sales, caused by the start of a
revenues, costs and recession or if a specific
profits. Keynes labelled market experiences
these “animal spirits.” falling demand.
Explain how a drop in business confidence can affect AD
Business confidence A drop in business If business sentiment
reflects expectations confidence might be declines, many will
about future sales, caused by the start of a choose to postpone or
revenues, costs and recession or if a specific cancel some planned
profits. Keynes labelled market experiences investment projects.
these “animal spirits.” falling demand.
Explain how a drop in business confidence can affect AD
Business confidence A drop in business If business sentiment
reflects expectations confidence might be declines, many will
about future sales, caused by the start of a choose to postpone or
revenues, costs and recession or if a specific cancel some planned
profits. Keynes labelled market experiences investment projects.
these “animal spirits.” falling demand.

A fall in investment will

reduce injections into
the circular flow of
income and lead to
contracting demand for
capital goods.
Explain how a drop in business confidence can affect AD
Business confidence A drop in business If business sentiment
reflects expectations confidence might be declines, many will
about future sales, caused by the start of a choose to postpone or
revenues, costs and recession or if a specific cancel some planned
profits. Keynes labelled market experiences investment projects.
these “animal spirits.” falling demand.

Thus, businesses A fall in investment will

manufacturing reduce injections into
machinery or building the circular flow of
new factories will see income and lead to
demand for their own contracting demand for
products falling. capital goods.
Explain how a drop in business confidence can affect AD
Business confidence A drop in business If business sentiment
reflects expectations confidence might be declines, many will
about future sales, caused by the start of a choose to postpone or
revenues, costs and recession or if a specific cancel some planned
profits. Keynes labelled market experiences investment projects.
these “animal spirits.” falling demand.

As a result, aggregate Thus, businesses A fall in investment will

demand will drop, and manufacturing reduce injections into
this might also lead low- machinery or building the circular flow of
confidence firms to new factories will see income and lead to
make some of their demand for their own contracting demand for
labour force redundant. products falling. capital goods.