What are the components of Aggregate Demand (AD) and their relative importance?

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

C - Consumption: Household spending on goods and services over time. It makes up roughly 60% of AD in the UK and is the largest component of AD.

I - Investment: Business expenditure on capital goods. It makes up roughly 15% of AD in the UK and is the 3rd largest component.

G - Government spending: Spending by the government on the economy such as spending on education and healthcare. It makes up roughly 24% of AD in the UK and is the 2nd largest component. 

(X-M) - Net trade: This is equivalent to the: (value of exports - value of imports). This makes up roughly 1% of AD in the UK and is the smallest component of AD.

What does the AD curve look like and what are movements along and shifts of the AD curve?

The AD curve is downward sloping, showing an inverse relationship between the price level and real output.

A movement along the AD curve will be caused by a change in the price level, resulting in either a contraction or extension in real output. A rise in the price level will result in a contraction in real output. A fall in the price level will result in an extension in real output.

A shift in AD occurs as a result of factors other than the price level changing. These factors could include changes in consumption, investment, government spending or net trade. A rise in AD will cause an outward shift of the AD curve. A fall in AD will cause an inward shift of the AD curve.

What factors influence consumption?

1. Disposable income. Disposable income is the money that households have for spending and saving after taxes have been paid. Higher levels of disposable income are likely to lead to an increase in consumption as consumers have more income to spend on goods and services.
2. Level of saving. When consumers save more of their disposable income, they have less money to spend on goods and services, hence leading to a fall in consumption.
3. Interest rates. When interest rates are high, this incentivises consumers to save a larger proportion of their income as they can earn a high rate of return on their money. Hence, an increase in saving due to higher interest rates will lead to a fall in consumption as when consumers save more of their income they have less money to spend on goods and services.
4. Consumer confidence. An increase in consumer confidence is likely to lead to an increase in consumption. This is because consumers are more willing to spend their money rather than save it as when there is more consumer confidence, there is likely less economic uncertainty.
5. Wealth effects. The positive wealth effect occurs when the general price of assets rises (for example an increase in house prices), likely leading to an increase in consumption as consumers feel wealthier.

What is gross and net investment?

Gross investment is the total expenditure on capital without taking into account the depreciation of capital stock, it includes expenditure on maintaining capital and increasing capital. Net investment is gross investment but taking into account the depreciation of capital stock.

What factors influence investment?

1. The rate of economic growth. When there are high levels of economic growth, there are likely to be high levels of aggregate demand in the economy in the economy. In order to meet this demand, firms are likely to invest in lots of capital, hence more investment is likely to take place when there are high levels of economic growth.
2. Business expectations and confidence. When businesses are confident and have positive expectations about the economy in the future, they are more likely to invest.
3. Animal spirits. Animal spirits are linked to the psychological factors which influence investment decisions such as optimism. Hence, animal spirits drive the willingness of firms to invest. During a period of heightened animal spirits, firms are more likely to invest.
4. Demand for exports. Increased demand for exports will likely lead to increased investment by firms in exporting industries in order to meet this extra demand for exports.
5. Interest rates. When interest rates are low, the cost of borrowing falls, meaning it is cheaper for firms to take out loans in order to fund investment, likely encouraging investment.
6. Access to credit. Larger firms are more likely to have better access to credit as they are deemed less risky due to their size. As these large firms have better access to credit, this may encourage investment.
7. The influence of government and regulations. High levels of corporation tax and other taxes on firms are likely to lead to a fall in investment as firms have less net profit to invest into the firm.

What factors influence government spending?

1. The trade cycle. During a recession, the government is likely to spend more on unemployment-related benefits as unemployment is likely to be high, leading to more government spending. During an economic boom, there is likely to be low government expenditure on these unemployment-related benefits, hence potentially reducing government spending.
2. Fiscal policy. Government spending will be dependent on what fiscal policy the government chooses to implement. For example, expansionary fiscal policy is likely to lead to larger levels of government spending than contractionary fiscal policy.

What factors influence net trade?

1. Real income. As real incomes fall, imports are likely to fall as consumers have less money to spend on imports. This is likely to improve net trade.
2. Exchange rates. If the exchange rate depreciates, imports become relatively more expensive and exports become relatively cheaper, likely leading to fewer imports and more exports. This improves net trade.
3. State of the world economy. If the global economy is strong, countries which export lots of goods and services are likely to see high levels of demand for their exports, leading to these countries exporting more, improving their trade balance.
4. Degree of protectionism. If a country implements lots of protectionist policies, this is likely to lead to a fall in imports into the country. This is likely to improve net trade.
5. Non-price factors. If the exports of a country become more non-price competitive (such as the exports of a country improving in quality or becoming more innovative), this is likely to lead to an increase in demand for the exports of this country, hence likely leading to more exports and an improvement in this country's net trade balance.