Aggregate Demand

A-level Economics

How we measure total spending in the economy

Definition: Aggregate Demand (AD) is measure of total expenditure within the domestic economy. It is broadly defined by the following formula:

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

What does the formula mean?

The different components of aggregate demand are Consumption (C), Investment Expenditure (I), Government Spending (G) and Net Exports (X-M). [Net exports means Exports (X) minus Imports (M)]

The formula allows us to calculate how much has been spent in the economy in a number of areas.

Consumption monitors the expenditure of households.

Investment monitors the expenditure of firms on capital goods and services.

Government spending monitors the expenditure of the government on public goods and services.

Net exports monitors the net expenditure on imports and exports. [For example, is more of our money being spent on foreign-made goods or is more money coming in to purchase our export products?]

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Let's show changes in aggregate demand in the diagrams below. For now, do not concentrate on the AS curves as this will be covered in the next article:

The diagram above shows aggregate demand increasing in the economy. Consumption, Investment, Government Spending or Net Exports have increased. This has caused Real GDP in the economy to increase. The increased spending has also incentivised firms to increase their prices. This is increase in prices is known as inflation, namely demand-pull inflation.

The diagram above shows the case where aggregate demand has fallen. Any of the component of aggregate demand could have decreased for this to happen.

How does aggregate demand affect the economy?

The levels of aggregate demand affects the economy in a number of ways:

Firstly, it has a direct effect on real gdp. If you remember the circular flow of income, you will also remember that when national expenditure in the economy increases it is matched by an increase in national income also.

Secondly, it has an effect on unemployment, more specifically cyclical unemployment. When aggregate demand increases, it means national expenditure has increased. Therefore, from the circular flow of income model, firms produce more goods by hiring more labour, as labour is a derived demand.

Thirdly, it has an effect on the price level in the economy, and therefore inflation. When spending levels rise, firms react by producing more and more goods. With the extra demand, comes the incentive to firms to increase their prices, and this is known as demand-pull inflation.

Next, it has an effect on the level of leakages. From the circular flow of income model, you should remember that leakges are savings, imports and taxation. When there is more aggregate demand in the economy, we should also expect the level of leakages to rise. National income will have risen, so people we expect imports to rise. Taxes should rise because there is more income to tax from. Total savings should also rise (as long as people save fixed proportions e.g. 10% of their income.

Next, we also expect the level of investment to rise when aggreate demand has increased in the past. This is called the accelerator effect. When businesses see that aggregate demand levels in the economy are strong, they are more likely to invest. Why? Because there is a greater chance of return from their investment as people are happy to spend. When the economy is booming it leads to more and more investment, which further increases AD and so on. Hence, why it is called the accelerator effect.

What have we learned?

1. The definition of AD

2. The AD diagram and what causes a shift

3. Some of the effects of AD on the economy