Components of Aggregate Demand

There are four components of aggregate demand, which simply refers to the summation of all demand in the economy. Households purchase consumer goods; businesses invest in capital goods; governments make purchases to provide key services; and exports to foreign consumers inject demand into the system, with domestic consumers buying imports causing a leakage. This leaves us with the formula AD=C+I+G+(X-M).

Consumer Expenditure

In the UK, consumers are responsible for over 60% of aggregate demand. This includes every household purchase made in the domestic economy from televisions to cars, haircuts to meals out. Consumer expenditure may rise or fall due to changes in:

• Disposable income. Most obviously, if people have more money available they will spend more. Levels of taxation will also influence this, as lower rates of tax boost disposable income.
• Rate of interest. This is the cost of borrowing and return from saving money. Lower rates of interest mean returns from saving reduce, encouraging consumers to spend their money instead. Additionally, if borrowing is cheaper and households are spending less on their mortgages they have more income left over to spend on goods and services in the economy.
• Propensity to consume. This simply means the proportion of income which is allocated to domestic spending (rather than saving, taxes or imported goods). Higher propensities to consume clearly help to boost levels of consumer expenditure.

Investment

Consumers are not the only purchasers of goods and services in an economy. Businesses are responsible for a component of aggregate demand in the form of investment when they purchase capital goods. By this we just mean goods which are used as part of the production process. Investment may rise or fall due to changes in:

• Rate of interest. Like consumers, businesses are affected by this, with lower rates of interest allowing cheaper borrowing to fund investment.
• Business profits. Higher profits provide greater funding for investment. This means that higher consumer spending will also feed into increased investment by providing businesses with more profit.
• Expectations. If there is more certainty about the future performance of the economy, businesses will have greater confidence to invest.

Government Spending

In the UK, the government provides healthcare and education free at the point of use. Spending is required on a variety of other areas such as infrastructure, public order and defence. All of this requires the purchase of goods and services as well, making government spending the third component of aggregate demand, which may rise or fall due to changes in:

• Political factors. Traditionally, right-wing governments tend to believe more in the power of free markets, meaning they tax less and spend less, supposedly allowing private businesses to operate without government interference. Left-wing governments favour a more significant role for the state in providing goods and services, which can result in higher levels of government spending.
• Economic situation. During recessions (periods when the economy is shrinking), governments tend to intervene with stimulus measures to get things moving again. This can necessitate higher levels of government spending than when the economy is booming.

Net Exports

Exports (X) are an injection into a country’s income flow, as they are products made at home and purchased by consumers abroad. Imports (M) represent a leakage because consumers at home are spending their money on products from abroad. The final component of AD is therefore net exports, which may rise or fall due to changes in:

• Exchange rates. This just means the price of a currency in terms of other currencies. A depreciation in the exchange rate will make exports cheaper, thus boosting demand for them. Simultaneously, it will make imports more expensive, so we won’t import as much. The combined effect would be to increase net exports (X-M). (Note that, in practice, the relationship between the exchange rate and net exports can be more complicated than this, but we will explore this further in a later brick.)
• Income at home. Higher income at home, while increasing spending on domestically produced goods and services, will also increase demand for imports. As a leakage, this would reduce net exports and put downward pressure on aggregate demand. Note that the impact on consumption would dwarf this effect and the net impact on AD of higher income would be overwhelmingly positive.
• Income abroad. Higher income abroad would increase demand for exports and would therefore be expected to increase net exports and aggregate demand.

The infographic at the top of the page can be downloaded here: