AGGREGATE

DEMAND
Theme 2 The UK Economy

Textbook pages 144151

What is Aggregate
Demand?

The total level of expenditure on all domestic goods and

services

Consists of:
Consumption (C)
+ Investment (I)
+ Government expenditure (G)
Net Exports
+ Export earnings (X)
Import expenditure (M)

Therefore, AD = C + I + G + (X M)

AD Curve:
The AD curve graphs the relationship between the price
level and real output
Always slopes downwards

Inverse relationship between PL and RO

PL
Lower price = Y1 to Y2 i.e. expansion
in AD
Higher price = Y2 to Y1 i.e. contraction
in AD

P1

P2
AD
Y1

Y2

RO

The AD curve slopes downwards because:

Purchasing power falls as the price level rises while incomes remain constant
therefore less demand
Imports become relatively cheaper as the UK price level rises and are
substituted for domestic demand

Understanding why the AD Curve

Slopes Downwards

Shifts in the AD Curve

A result of an endogenous shock (Greek

1.

for coming from inside)

A change in a component of AD

A result of an exogenous shock, (Greek for

2.

coming from outside)

A change in a variable which affects at least

one of the AD components, but which itself is
outside the AD model

Effectively, a shift in AD shows how real

output has changed independently of PL

External Shocks to Aggregate Demand

Many unexpected events cause changes in
demand, output and employment. These events are
called external shocks.

Price
Level

P1

AD2
AD1
AD3
Y3

Y1

Y2

Real Output

For a rightward shift of AD, there must be an increase in

Consumption, Investment, Government Spending or Net Exports
Evaluation: If there was a 10% increase in each component, which
change would increase AD by the greatest amount?

1.

Real Income
This is the main influence on consumer expenditure.

The Average Propensity to Consume (APC) is the proportion of

income that households devote to consumption
APC = Consumption/Income or C/Y
Example: Sarahs wage after allowing for tax is 500 per week;
of this, she spends 450 per week in total. What is Sarahs
APC?

The Marginal Propensity to Consume (MPC) is the proportion of

an increase in disposable income that households devote to
consumption

The Marginal Propensity to Save (MPS) is the proportion of an

increase in disposable income that households devote to
saving

Take notes from p.146/147 and Qu.Skills 11.1, 11.2

What influences the MPC?

2. Wealth

Leads to wealth effect change in consumption

due to a change in the wealth of an individuals
(either positive or negative)

3. Consumer Confidence/Expectations
4. Interest rates

Lower interest rates = higher consumption due to:

It is cheaper for consumers to borrow

It reduces the incentive to save
People with mortgages have more money to spend.

Why may spending not always rise when interest

rate falls?

5. Demographics

Young/elderly typically have a high APC

why?

6. Distribution of income

Poor people spend a higher proportion of

their income than rich people why?

7. Income tax level

8. Unemployment rates

Investment
Increased business confidence (economic
cycle)
Increased

profitability

Low

risk business environment e.g.

political instability / election

Falling

IR e.g. 2009 0.5%

Government

policies promoting
investment e.g. investment subsidies or
Enterprise Zones (Docklands, 1980s)

Key

Question: how easy is it for

government to control investment levels?

Public and Private Sector Debt

Public sector debt is owed by central and local

government and by public (state-owned)
corporations

Private sector debt is owed by private businesses

and households.

Debts owed by state-owned banks are included in national

debt

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

The Scale of Debt in the UK Economy

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.

UK Household Debt Relative to

Disposable Incomes

Short term loans include outstanding debt on credit

cards

Consequences of Debt for an economy

such as the UK

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.

Government spending
Change of Gvt policy, leading to a rise in Gvt spending, e.g.
NB: This does not include spending on transfer payments.

Exports imports
A rise in UK (external) price competitiveness, e.g.
Fall in sterling ER
Fall in IR (which leads to a fall in sterling ER)

A rise in the UKs non-price competitiveness, e.g. better

Quality and reliability
Innovation and technology e.g. Dyson
Branding

Economic boom abroad (major trading partners or globally)

Q: Examples of changes in recent history?

Q: What will determine the scale of the impact of change in the exchange
rate on net exports?

Exports Imports (evaluation J curve)

In the SR a change in the exchange rate will not

immediately change net exports, there is a time lag

In the SR there will be a low PED for imports and

exports, this is due to most large trade deals being fixed
contracts.
A depreciation in the vs a trading partner will make

imports more expensive but in the SR we still are committed

to purchase these, therefore we spend more on them and
the value of imports rises (volume remain constant)
Exports cheaper but in the SR demand will be unresponsive
due to fixed contracts so exports earnings do not
compensate for the rise in import expenditure

AD: The specifics

1.

2.

3.

4.

5.

6.

An increase in the price level in the UK is likely to lead to more

goods being imported and fewer being exported. Why does AD
not shift left?
What is meant by the terms endogenous and exogenous
factors?
Why does a rise in the value of an individuals assets lead to an
increase in consumption?
Which form of government spending should not be included as
part of AS/AD analysis?
Investment is one component affecting AD. What is meant by
this term in the context of AD/AS analysis?
How is a rise in the interest rate likely to affect the exchange
rate and hence AD? How can this point be evaluated?