2.2.3 The Determinants of Aggregate Demand

Consumption

Consumption: Spending by households on goods and services. It is the largest component of aggregate demand.

Disposable Income: Income available for spending after direct taxes and after adding government transfer payments such as benefits.

Consumption is primarily determined by disposable income: a rise in disposable income raises consumption, and a fall lowers it.

The Savings Relationship

Disposable income is split between consumption and saving.

The marginal propensity to consume (MPC) is the proportion of an increase in disposable income that is spent, and the marginal propensity to save (MPS) is the proportion that is saved. As the two shares must add up, MPC + MPS = 1.

For example, if a household receives an extra £100 of disposable income and spends £80 of it, the MPC is 0.8 (and the MPS is 0.2).

Other Key Influences on Consumption

• Interest rates: Higher rates raise the cost of borrowing and increase the reward for saving, reducing consumption. Lower rates do the reverse.
• Consumer confidence: When households are optimistic about their future income and the economy, they spend and borrow more; pessimism reduces consumption.
• Wealth effects: A rise in household wealth, such as higher house or share prices, makes households feel wealthier and spend more; falling wealth reduces consumption.
• Distribution of income: A more equal distribution tends to raise consumption, because lower-income households have a higher MPC than higher-income households.

Investment

Investment: Spending by firms on capital goods, such as machinery, factories, and technology, in order to increase future productive capacity.

Gross investment is total spending on new capital plus the replacement of worn-out capital. Net investment is gross investment minus depreciation — the net addition to the capital stock, which is what raises the economy's productive potential.

Depreciation: The loss of value of capital goods over time due to wear and tear or obsolescence.

Key Influences on Investment

• Rate of economic growth: Faster growth leads firms to expect higher future demand, encouraging investment.
• Business confidence and "animal spirits": Optimism about the future — driven partly by sentiment and emotion — encourages investment; pessimism delays it.
• Interest rates: Lower rates reduce the cost of borrowing, making investment more attractive.
• Access to credit: Easier access to finance makes it simpler for firms to fund capital projects.
• Demand for exports: Higher export demand can prompt investment in extra production capacity.
• Government policy and regulation: Tax incentives can encourage investment, while regulation can discourage it.

Impact of Investment

Short run: Investment is a component of AD (AD = C + I + G + (X - M)), so a rise in investment increases aggregate demand, supporting growth and lower unemployment.

Long run: Investment raises the economy's productive potential and can shift long-run aggregate supply (LRAS) to the right, supporting non-inflationary growth.

Government Spending

Government spending, or G, is spending by the government on goods and services such as public services and infrastructure. It is a component of aggregate demand: AD = C + I + G + (X - M).

Key Influences on Government Spending

The economic cycle (automatic stabilisers): Spending changes automatically over the business cycle. In a recession it rises as welfare claims increase, supporting AD; in a boom it falls as welfare claims decline, helping cool the economy.

Discretionary fiscal policy: Governments can deliberately change spending — expansionary policy raises G (e.g. on infrastructure) to boost AD, growth, and employment, while contractionary policy cuts G to reduce inflation or a budget deficit.

Political and social priorities: Spending also reflects manifesto commitments (e.g. defence or hospitals), demographic pressures such as an ageing population (pensions and healthcare), and long-term supply-side aims like infrastructure and education that shift LRAS to the right.

Impact of Changes in Government Spending

On AD: A rise in government spending directly increases aggregate demand; its effect on real GDP, employment, and inflation depends on how much spare capacity there is.

On LRAS: Spending on infrastructure, education, and technology can raise productive capacity and shift long-run aggregate supply to the right.

Net Trade

Net trade: Exports minus imports (X - M), a component of aggregate demand. A surplus (\( X > M \)) adds to AD, while a deficit (\( X < M \)) subtracts from it.

Key Influences on Net Trade

• Real incomes: Higher domestic real incomes increase spending on imports, worsening the trade balance; higher foreign real incomes raise demand for exports, improving it.
• Exchange rates: A depreciation makes exports cheaper and imports dearer, improving the trade balance (an appreciation does the reverse). The size of the effect depends on the price elasticity of demand for exports and imports, so a depreciation may worsen the balance in the short run before improving it in the long run.
• State of the world economy: Global growth raises demand for exports and improves the balance, while a global recession worsens it. This is often the most important short-run driver for the UK, a relatively open economy.
• Protectionism: Tariffs, quotas, and subsidies can reduce imports and improve the balance, but may provoke retaliation that reduces exports and raise prices for consumers.
• Non-price factors: Quality, branding, and innovation affect competitiveness — stronger domestic competitiveness raises exports and improves the balance.

Accelerator Effect

The accelerator effect is the idea that a rise in the rate of economic growth results in a larger percentage rise in investment. Firms invest in new capital to meet higher expected demand, so a rise in national income can lead to a larger percentage rise in investment, which further boosts aggregate demand and growth.

The accelerator effect can also work in reverse: a fall in growth can lead to a larger percentage fall in investment, which further reduces aggregate demand and growth.