Components of Aggregate Demand

Components of Aggregate Demand

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

   • Factors that affect Consumption and Saving
     • Income - generally, as disposable income increases consumption rises. The rate at which consumption rises is usually lower than the rate at which income increases because households tend to save more as well.
       • Interest Rates - higher interest rates lead to less consumer spending - they save instead. Less likely to borrow money as it is more expensive. Consumers may have less money to spend if interest rates on existing loans and mortgages increase.
         • Consumer Confidence - when consumers feel more confident about the economy and their own finances, they spend more and save less. Lower confidence can be caused by a recession - reluctant to spend and losing jobs. This can continue even after a recession.
           • Wealth effects - rise in household wealth, such as due to rise in share or house prices, leads to rise in consumer spending and reduction in saving. This is because of consumer confidence - if house prices rise faster than inflation, home owners feel more confident in their own finances.
             • Taxes - direct tax increases lead to fall in consumers' disposable income so they spend less. Indirect tax increases e.g. rise in VAT, increases cost of spending, so consumers tend to decrease consumption. A reduction in direct or indirect taxes leads to higher consumer spending.
               • Unemployment - when unemployment rises consumers spend less and save more due to being worried about losing jobs. A fall in unemployment means more people have money to spend and consumers are less worried about losing their jobs, so consumer spending increases.

2. Investment - money spent by a firm on assets that they will use to increase productive capacity.

   • Gross investment - includes all investment spending
   • Net investment - investment that increases productive capacity
     • e.g. if a firm has 3 old trucks and replaces them with 5 new trucks, gross investment is 5 trucks, but net investment is 2 trucks.

3. Saving - The portion of disposable income not spent on consumption

4. Factors that affect Investment

   • Risk - If there is a high risk and not much gain, it is unlikely for the firm to invest. Less economic stability means less investment.
     • Govt incentives and regulation - such as subsidies or reductions in tax can affect investment. e.g. a reduction in corp tax may encourage firms to invest. A relaxing of govt regulations may reduce firms costs and increase their investment.
       • Interest rates and access to credit - When interest rates are high, firms less likely to borrow money, investment decreases.
         • Technical advances - firms need to invest in new tech to stay competitive. Investment will rise when signifiant technological advances are made.
           • Business confidence and 'animal spirits' - More confidence means more likely it is to invest. Business confidence depends partly on general optimism or pessimism of company's managers. Keynes recognised not all investment decisions are based purely on reason, but intuition and gut instinct, AKA 'animal spirit'.

5. Factors that affect Imports and Exports

   • Several factors affect the net exports component of AD
     • Exchange rate - In long run, stronger currency means more imports and less exports. However, in the short run demand for imports and exports is quite price inelastic due to not many substitutes available (due to amount of time it takes - e.g. oil).
       • Changes in state of the world economy - For example, USA exports lots of goods to Canada. If Canada goes through a period of low growth there exports from USA to Canada will decrease.
         • Degree of protectionism - In the short run, tariffs and quotas can decrease imports/increase exports.
           • Non-price factors - e..g quality of goods. For example, advancements in tech in a country lead to production of higher quality goods is likely to cause increase in exports as people are willing to pay more for it.