Aggregate Demand (AD) Curve: The aggregate demand curve depicts the relationship between the level of aggregate demand and the price level, i.e., it can also show theoretical expenditure at any price level on the graph.
Consumption: The amount consumed of anything (e.g., goods and services)
Disposable Income: The amount of a person's or group's monetary income which is available to be saved or spent (on either essential or non-essential items), after deducting all taxes and other governmental fees.
Interest Rate: The percentage of an amount of money charged for its use per some period of time.
Consumption Function: A function that describes the relationship between consumption and disposable income.
Investment: A placement of capital in expectation of deriving income or profit from its use or appreciation
What Makes Up the Aggregate Demand?
Aggregate demand depicts the total demand in an economy at a national level. However, before we understand how aggregate demand works, we must look at what it comprises off. The main components of aggregate demand are:
Consumption (C) – This is the amount consumed by households, through the purchase of goods and services.
Investment by Firms (I) – Investment by firms into capital and the creation of new infrastructure also affects aggregate demand.
Government Expenditure (G) – Expenditure by the government also influences aggregate demand with it increasing when there is government expenditure.
Net Exports (X-M) – Exports subtracted by imports also influences aggregate demand, with increase in imports leading to an increase in AD whilst an increase in imports leads to a fall in AD.
All these components can be arranged in the following equation:
AD = C + I + G + (X-M)
Consumption can also be regarded as consumer expenditure, the more that consumers spend aggregate demand increases and vice versa. The main determinants of consumption are:
Disposable Income – The more income that households have after taxes and any other compulsory expenditure and the greater the marginal propensity to consume the more aggregate demand goes up.
Wealth – The greater the wealth a family or household has the larger the spending capability, as wealth is a collection of assets that can be sold for liquid cash or can generate a flow of income such as rent.
Rate of Interest – The lower the interest rate the more firms and households can borrow and spend such as being able to take out a loan to build a house extension or buy that new car, this also increases aggregate demand.
The consumption function depicts the relationship between consumer expenditure and real income.
As can be seen above as real income goes up so does consumer relationship showing a direct relationship. However, it is important to know that this is only a theoretical interpretation (ceteris paribus) and that in real life there may be factors that might prevent this from happening.
Investment is also a component of aggregate demand; this is because investment leads to an increase in the productive capacity of the economy. In order for firms to be able to invest majority have to take out some form of borrowing. The amount of borrowing a firm takes out is dependent on the interest rate, the higher the interest rate the lower the investment as the cost of borrowing is greater and vice-versa. This can be represented on the following graph:
It is important to understand that firms do not need to borrow in order to invest, they may be able to do it out of profits however this only applies to firms that are able to generate a substantial profit (think back to market structures). Additionally, there may be an opportunity cost of using profit for investment such as the purchasing of financial assets.
Government expenditure also impacts aggregate demand, as it often can increase the marginal propensity to tax, and expenditure based on its decisions. For example, if taxes decreases consumers marginal propensity to taxes also decreases leading to an increase in household consumption. It is crucial that you take into account the impacts that government expenditure (and actions) has on aggregate demand.
Net exports is also a component of aggregate demand. There are several factors that influence whether net exports are export leaning or import leaning for example:
Nature of Goods/Services - If the good or service imported is a normal good as wages go up so will the consumption of the goods or services. Same applies if our exports are normal goods.
Economic Growth - The current position of the economy also impacts net exports, for example during recession time fewer imports are bought and fewer exports are sold.
Exchange Rate – Exchange Rate also impacts the competitiveness of trade if the UK Sterling Pound became stronger in comparison to the Euro (who let us suppose we are trading with) more people would buy European imports as they are cheaper and less European countries would purchase our exports as they have become more expensive.
Inflation – Inflation rate also impacts trade, with countries facing higher inflation having increased prices for their exports which reduces sales and vice versa.
Elasticity – The elasticity of our exports and imports also affects trade. If our exports are inelastic, they may be more resistant to price changes, whilst if they are elastic they suffer more.
It is important to note that all these factors work both way, inflation could be high or low, exchange rates could be high or low, economic growth could happen or it could not.
Expectations also influence the various components of aggregate demand. Its all down to how firms and households view the future. If households predict that there may be a recession or inflation on the way, they may choose to save more, decreasing consumption.
Same applies for firms who may think that the rate of interest will the decrease in the future, they may choose to postpone investment. This may have a self-fulfilling element to the economy and aggregate demand may start to fall.
References/ Further Reading:
Aggregate Demand – Wikipedia - https://en.wikipedia.org/wiki/Aggregate_demand