The Components of Aggregate Demand

The Components of Aggregate Demand

• Consumer expenditure is also known as consumption
  • For most countries, it is the largest component of aggregate demand.
  • Examples of consumer expenditure include spending on items like clothing, food and insurance.
• Investment is the most volatile component of aggregate demand
  • This includes things like spending on capital goods, such as delivery vehicles, machines, and office buildings
  • Spending on such items may rise by 60% one year, and fall by 20% the next
• Government spending is spending by the central and local government
  • It involves spending on things like education, health care, and the police service.
  • It does not include transfer payments such as job seeker’s allowance and state pensions
    • This is because such payments do not involve the government itself buying goods and services.
  • If job seeker’s allowance was increased, this would be reflected in higher consumer expenditure.
• Net exports are what foreigners spend on the country’s goods and services, minus what the country’s citizens pay on foreigners’ goods and services.
  • This can make a positive or negative contribution to aggregate demand
  • If exports are greater than imports, then the country has a trade surplus, if it’s the other way round, it’s a trade deficit.
    • A trade deficit means that aggregate demand would be lower than total domestic demand.

Factors that Affect Consumer Expenditure

• Real Disposable Income
  • This is the main influence on consumer expenditure
  • Richer households and richer economies tend to spend more than poorer ones, as they have more money to spend.
  • The proportion of income that is spent (average propensity to consume [APC]) may fall as disposable income rises.
• Wealth
  • The more wealth – in terms of things like houses, savings accounts and shares – that people have, the more they tend to spend
  • Wealth is linked to consumer confidence – if house prices went up, consumers would feel wealthier, and would spend more.
• Consumer Confidence and Expectations
  • When consumers are feeling optimistic about the future, they spend more.
  • This is why proportion of income spent can rise as income rises
• The Rate of Interest
  • Usually, a fall in the rate of interest will stimulate a rise in consumer expenditure. This is because:
    • It makes it cheaper for consumers to borrow in order to buy things like cars
    • It reduces the incentive to save, as one won’t get as much
    • Those that are paying interest on a loan will have more money to spend
  • The Age Structure of the Population
    • The young and elderly spend a high proportion of their disposable income, whereas the middle-ages are more inclined to save and have mortgages, etc.
  • Distribution of Income
    • Poor people spend more of their income than rich people
    • Introducing policies that distribute income from the rich to the poor are likely to increase consumer spending.
  • Inflation
    • If people expect prices to rise, then they’ll be likely to spend

Factors that Affect Saving

• Saving is not a component of aggregate demand, but it does influence the spending undertaken by households, firms, the government and foreigners.
• Real Disposable Income
  • This is the main influence on saving
  • As RDI increases, households not only save more, but also save a higher proportion of their income – their average propensity to save (APS) rises.
• The Rate of Interest
  • A rise in the rate of interest means more people will want to save
• Confidence and Expectations
  • When households are uncertain or concerned about the future, they are likely to save more, as a precaution against a sudden drop in income.
• Saving Schemes
  • Contractual saving, like pension schemes are when people agree to save a certain amount on a regular basis.
• Range of Financial Institutions
  • If there are a number of respected and established financial institutions, people will find it easy to save, and they will have the confidence to place their savings with these institutions
  • However, it’s also the case that as a financial system becomes more developed, saving rates may fall, because people find it easier to borrow.
• Government Policies
  • If the government introduces a policy for tax-free saving, then more people will save
  • Or, if it increases state pensions, people will be less likely to save.
• The Age Structure of the Population
  • When people are young, they save very little
  • The middle aged tend to save the most
  • The elderly dissave – drawing from their savings to maintain their living standards.
  • However, this isn’t always true, as some pensioners continue to save in case they need medical treatment, or to pass more onto their kids.

Factors that Affect Investment

• Firms invest when they expect to receive a profit from the cost of capital goods.
• Changes in Disposable Income
  • If real disposable income rises, demand for consumer goods & services will be rising
  • This may encourage firms to expand their productive capacity
  • However, a rise in disposable income doesn’t necessarily mean companies will expand their capacity – they have to be sure that their existing capital goods are not sufficient to produce the extra output.
• Expectations
  • If firms feel more optimistic about future prospects, they’re more likely to invest.
• Capacity Utilisation
  • Firms are more likely to invest if they’re operating close to full capacity
• Current Profit Levels
  • High profit levels encourage investment in two ways
    • They provide the finance to invest
    • They are likely to contribute to firms’ optimism about the future
  • Corporation Tax
    • Corporation tax taxes the firm’s profits
    • A cut in corporation tax increase the amount of profit, which firms can use to invest
    • A government can also stimulate investment by providing investment subsidies.
  • The Rate of Interest
  • A rise in the rate of interest would be likely to reduce investment because:
    • It will increase the opportunity cost of investment
      • Putting money in the bank, for example, could yield higher profits
    • It makes it more expensive to borrow, and so may discourage some investment projects
    • It will affect the expected return on the investment
      • Firms will anticipate that consumer spending will fall
    • It reduces the demand for shares
      • Some people who might have bought shares will put that money in a bank, for it to gain interest.
      • Lower demand for shares means their price will decrease, and so the firms get less from them.
    • Advances in Technology
      • If there are significant advances in technology, it is likely that a firm will buy new capital equipment, as it is expected that the new technology will generate higher profits.
    • Price of Capital Equipment
      • A reduction in the price will increase investment, as it means firms can either now afford the equipment, or it is an incentive for firms that already have it to increase their capacity.

Factors Affecting Government Spending

• The Government’s View on the Extent of Market Failure – Politics of the Government
  • If the government is highly interventionist, government spending would be expected to be a high proportion of Aggregate Demand.
• The Level of Economic Activity in the Economy
  • If there is high unemployment, a government may increase its spending to increase aggregate demand
  • In contrast, if there’s high inflation, a government may reduce its spending.
• A Desire to Please the Electorate
  • If the public want more money spent on public services like education and transport, then the government should spend more.
• War, Terrorist Attacks, Rising Crime… etc.
  • All of the above can cause the government to spend more.

Factors Affecting Net Exports

• Real Disposable Income Abroad
  • If income abroad rises, it is likely to result in more exports being sold.
• Real Disposable Income at Home
  • This may result in net exports falling, as firms may focus on selling products to meet the demand at home.
• The Domestic Price Level
  • If domestically produced products become more expensive, firms and consumers will switch to products made from other countries, and so net exports would decrease, as more items are being imported than exported.
• The Exchange Rate
  • A fall in a country’s exchange rate will reduce the price of exports and increase the price of imports, which, in turn, is likely to result in a rise in net exports
• Government Restrictions on Free Trade
  • A country’s net exports may rise if other countries remove trade restrictions.