AD Notes

1. Aggregate Demand
EdExcel AS Economics 2.2.1

2. Meaning and Measurement of Aggregate Demand
• Aggregate Demand (AD) =
– Total level of planned real expenditure on the goods and
services produced within a country
• The components of aggregate demand are:
– Household spending on goods and services (C)
– Gross Fixed Capital Investment Spending (I)
– Value of the Change in Stocks (Inventories)
– Government Consumption (G) (Public services)
– Exports of Goods and Services (X)
– (minus) Imports of Goods and Services (M)
• GDP (expenditure-based) is the actual value of expenditure
• Changes in AD are key to understanding short-term fluctuations
in a cycle e.g. recession and recovery, boom and slowdown

3. Components of UK Aggregate Demand 2007-2015
Source: HM-Treasury Databank
Consumption
(C)
Government
Spending (G)
Investment
(I)
Exports
(X)
Imports
(M)
Year Per cent Per cent Per cent Per cent Per cent
2007 2.8 1.2 5.3 -2.1 -0.8
2008 -0.5 2.0 -4.7 1.6 -1.8
2009 -3.3 1.2 -14.4 -8.2 -9.8
2010 0.5 0.0 5.9 6.2 8.7
2011 -0.1 0.0 2.3 5.6 1.0
2012 1.5 2.3 0.7 0.7 3.1
2013 1.7 -0.3 3.4 1.5 1.4
2014 2.6 1.6 8.6 0.5 2.4
2015

4. The Relative Importance of Components of AD
Source: HM-Treasury Databank
Consumption
(C)
Government
Spending (G)
Investment
(I)
Exports
(X)
Imports
(M)
Year £m £m £m £m £m
2007 1021 326 294 477 538
2008 1016 333 281 485 528
2009 982 337 240 445 476
2010 987 337 254 472 518
2011 985 337 260 499 523
2012 1000 345 262 502 539
2013 1018 344 271 510 547
2014 1044 349 294 512 560
2015
Consumption is far and away the biggest component of AD

5. The Aggregate Demand Curve (AD)
General
Price Level
Real GDP
AD =
C+I+G+(X-M)
GPL1
Y1Y2
GPL2
GPL3
Y3
A rise in the price level causes a
contraction of AD

6. The Aggregate Demand Curve (AD)
General
Price Level
Real GDP
AD =
C+I+G+(X-M)
GPL1
Y1Y2
GPL2
GPL3
Y3
A rise in the price level causes a
contraction of AD
A fall in the price level
causes an expansion of AD

7. Understanding why the AD Curve Slopes Downwards
Falling real
incomes
• As the price level rises, the real value of income falls
and consumers are less able to buy what they want or
need – this is known as the real balance effect
Balance of
trade
• A persistent rise in the price of level of Country X
could make foreign-produced goods and services
cheaper, causing a fall in exports and a rise in imports
Interest
rate effect
• If the price level rises, this causes inflation and an
increase in demand for money and a possible rise in
interest rates on loans which then has a deflationary
effect on consumer and business demand

8. Shifts in the Aggregate Demand Curve (AD)
General
Price Level
Real GDP
AD1
GPL1
Y1
AD2
Y2
AD3
AD1 – AD2: Outward
shift – will raise national
output at all price levels

9. Shifts in the Aggregate Demand Curve (AD)
General
Price Level
Real GDP
AD1
GPL1
Y1
AD2
Y2
AD3
Y3
AD1 – AD2: Outward
shift – will raise national
output at all price levels
AD1 – AD3: Inward shift
– will reduce national
output at all price levels

10. Examples of Causes of Shifts in Aggregate Demand
Fall in AD
Fall in exports
Cut in government
spending
Higher interest rates
Decline in household
wealth
Increase in AD
Depreciation of the
exchange rate
Cuts in direct and indirect
taxes
Increase in house prices
Expansion of supply of
credit + lower interest rates

11. Changes to Monetary Policy
• Changes in official monetary policy interest rates
• Change in the supply of money and credit
• Change in the value of a country’s exchange rate
Changes to Government Fiscal Policy
• Changes in the level of direct / indirect taxes
• Changes in government (state) spending
• Changes in government (fiscal) borrowing
Business and Consumer confidence
• Planned capital investment spending by businesses
• Consumer confidence and retail spending
Focus on Key Causes of Shifts in Aggregate Demand

12. External Shocks to Aggregate Demand
Many unexpected events cause changes in demand, output and
employment. These events are called external “shocks”.
A large rise or fall in the value of the exchange rate
A recession, slowdown or boom in one or more of a nation’s key
trading partner countries
A slump in the housing market / construction sector of a country
An event such as the Global Financial Crisis which caused a fall in
the supply of credit available to businesses and households
A large change in commodity prices for a country that
is a commodity exporter

13. Exports of Goods and Services (X)
Relative Prices
of exports in
World Markets
The exchange
rate – a
stronger
currency makes
exports more
expensive
Non-Price
Demand
Factors e.g.
Design and
Branding
Strength of
Aggregate
Demand in Key
Export Markets
Exports are goods and services sold to other countries. Exports are
an injection into a nation’s circular flow of income and spending
Many factors affect the
level of demand for a
nation’s exports – some of
these are shown on the left

14. The Net Trade Balance (X-M) and Aggregate Demand
The net trade balance is measured the value of exported goods and
services minus the value of imported products
A trade surplus means
that X>M – aggregate
demand will increase
A trade deficit means
that M>X – aggregate
demand will fall
If X=M, then the trade
balance is zero, external
trade will have a
neutral effect on AD 0
50
100
150
200
250
300
350
400
450
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
TradebalanceinbillionU.S.dollars
Balance of Trade for China 2000-2014

15. • Public sector debt is owed by central and local
government and by public (state-owned) corporations
– Debts owed by state-owned banks are included in national
debt
• Private sector debt is owed by private businesses and
households.
– Companies may have borrowed to finance investment
(corporate sector debt)
– Households have loans for example credit card debt and
mortgages on properties.
• Financial debt is also part of the private sector – this is
the outstanding (unpaid) debts of banks and financial
corporations - for example the level of bad debts on
loans to businesses and to the housing market
Public and Private Sector Debt

16. • In the spring of 2013, household
and non-financial firms’ debt
amounted to 208% of UK GDP –
down to levels last seen in mid-
2007, but significantly higher than
they were a decade ago (170pc of
GDP) and 15 years ago (128pc of
GDP).
• The UK private debt/GDP ratio is
high by historical and international
standards, and far above the 160%
level used by the EU Commission
as a threshold for gauging
imbalance in debt to income levels
for EU member states.
The Scale of Debt in the UK Economy

17. UK Household Debt Relative to Disposable Incomes
60
70
80
90
100
110
120
130
140
150
160
1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
Short-term Loans
Long-term Loans
Stock of outstanding loans to households, % of households’ disposable income
• Short term loans include outstanding debt on credit cards
• Long term loans include mortgage debt

18. • Debt acts as a constraint on future spending power.
– Millions of people in the UK are saddled with many thousands
of pounds of debt and the interest payments on this debt
reduces their effective disposable income
• The commercial banks also have high debt and this restricts their
ability to make fresh loans to businesses and households who
want to borrow. This can limit business investment
• The economy can be at risk with a high debt-to-GDP ratio
– If price deflation happened, falling consumer prices and
incomes would make the debt problem even worse in real
terms
– When nominal interest rates rise, many households –
especially mortgage payers - are at risk and can struggle to
meet repayments. This could cause a slowdown or a possible
recession in the housing market.
Consequences of Debt for an economy such as the UK

19. Aggregate Demand
EdExcel AS Economics 2.2.1