Aggregate demand and supply analysis is very similar to the analysis in the 'Supply and demand' topic. The big difference is that aggregate demand and supply refer to the aggregates of the whole economy. The supply and demand analysis in the first topic is used in microeconomics to look at the behaviour of individual consumers, producers and industries. Inevitably, when dealing with aggregates it all gets a little bit more complicated. The good news, though, is that the diagrams look quite similar.
Aggregate demand is the sum of all planned expenditures in the economy. We said in the last Learn-It that this is C + I + G + X − M. The aggregate demand curve shows the amount of goods and services in the whole economy that are demanded at any given price level. The price level here is not the price of any one good, but the average price level for the whole economy.
Note that the x-axis is labelled real national income, but in brackets it is also called 'real output' and 'real expenditure'. Remember that these three things are equal because they are three different ways of measuring the same money flowing around the economy (see the Learn-It on the 'Circular flow of income')
As you can see, the aggregate demand (from now on, AD) curve has the familiar downward slope. At a higher price level (P1) the demand for real national income will be relatively low (Y1) and at a lower price level (P2) the demand for real national income will be relatively high. This is a bit like the demand curve for any normal good, but the reasons behind the downward sloping AD curve are a little more complex.
We could explain this by going through each of the components of AD (C, I, G, and X − M) to see why the real expenditure in each category changes as the price level changes. This can get confusing, though. There are three main factors that explain the shape of the AD curve, some of which will affect more than one component of AD.
Remember that for each of these explanations, we are talking about a movement along the AD curve, not a shift in the curve (see the next section). The initial move is always a change in the price, which then causes the following three things to happen.
- Interest rates:
If the price level rises, the rate of interest rises in an effort to stop the price rise getting out of hand (see the topic 'Unemployment and inflation' for details of why this is bad). Consumers' mortgage payments will rise (in the UK, the majority of people have variable rate mortgages). This means that consumers will have less money left over to buy goods and services. Higher interest rates make it more expensive for consumers to buy 'big ticket' items, like new cars, for which money tends to be borrowed. In the same way, firms are less likely to borrow for investment. So, in response to a rise in the price level, the final effect is a fall in planned consumption and investment, and so a reduction in AD. In the old days, the government would rather not raise interest rates until they had to, because it made many people (voters!) feel less well off. They tended to raise rates in response to a rising price level. Nowadays the Monetary Policy Committee (MPC) of the Bank of England acts pre-emptively, raising rates in anticipation of a future price rise to stop it ever happening.
- Changes in real wealth:
If the price level rises, for a given level of nominal wealth, then peoples' real wealth will fall. This will be true for incomes too if nominal incomes remain constant. Basically, people will feel less well off, and so will probably consume fewer goods and services.
- The foreign sector:
For a given exchange rate, if the UK price level rises, then home produced goods will become relatively more expensive in other countries, and so the demand for exports will fall. Also, imports into the UK from other countries will appear relatively cheaper, because their price level has remained unchanged while the price of the home produced goods are rising. The demand for foreign imports will, therefore, rise. Both of these effects cause the level of real national income to fall as the price level rises. Note that sustained differences in the price levels of two different countries will eventually cause the given exchange rate to change. See the topic called 'Exchange rates' for details.
For all three of these explanations, one can reverse the analysis when considering a fall in the price level. Also, note that none of the factors affected government spending (G). In these models it is assumed that government spending is exogenous, which means 'determined outside the model'. In other words, increases in real government spending tend to be unrelated to changes in the price level. In the summer of 2000, the then Chancellor Gordon Brown announced huge increases in real government spending and yet the price level had been fairly stable. Perhaps the fact that the next general election was looming had more to do with the change in government policy.
It is important to understand why curves shift, both in the world of microeconomics (why might the demand curve for chocolate bars shift to the left or to the right?) and in the world of macroeconomics (why might the AD curve for the whole economy shift?). It is certainly a bit more confusing when we look at AD. It should be noted, for instance, that interest rates are a cause of a movement along an AD curve (following a rise in the price level) and can also cause a shift in the AD curve (when the change in the rate of interest happens independently of a change in the price level).
In the diagram above, the AD curve has shifted to the left, from AD1 to AD2, so that real national income falls at any given price level. At P1, for example, real national income has fallen from Y1 to Y2 as a result of the inward shift of the AD curve.
Why might this have happened? I mentioned interest rates above. What if interest rates are raised even though the price level remains constant (i.e. not as a result of a change in the price level, which would be a movement along the AD curve). It was explained above that in the relatively new world of the Monetary Policy Committee, interest rates are often raised in anticipation of future rises in the price level, and not as a result of a change in the price level itself. This will cause all the effects mentioned above: reduced consumption because of higher mortgage payments; a reduction in the demand for 'big ticket' items and a reduction in investment by firms.
We now need to think of other 'big' macro reasons.
- Unemployment: When unemployment rose during the recession of the early 90s, many households' purchasing power was greatly diminished. The demand for goods and services, and therefore AD, fell whatever the price level was.
- Taxation: Although income tax (a direct tax) rates fell during the 80s, indirect taxes increased (see the topic called 'Taxation and government spending' for much more detail). A similar thing is happening at the moment. The Labour government have raised the tax burden, even though taxes directly on income have fallen slightly. This will have the effect of reducing AD whatever the price level; households will have less disposable income to spend. Businesses pay taxes as well. Increased business taxes may cause a firm to reduce investment if it feels it can no longer afford it.
- Government spending: Gordon Brown's big increase in real government spending was mentioned earlier. Obviously this will increase real national income for any given price level. But the Chancellor was very cautious with taxpayers' money until a year before the 2001 election. In real terms the increases in spending were very low indeed. If government spending actually fell in real terms, then the AD curve would shift from AD1 to AD2.
- The stock market: For most of the 90s the stock market has performed relatively well. In October 1987 and 2008, there were big crashes in world stock markets. For those who had much of their wealth tied up in stocks, both directly and indirectly (through their private pension plans) this was bad news. They felt less wealthy and this would directly affect the amount they spent. The AD curve shifted to the left, ceteris paribus.
- Business confidence: This is fairly straightforward. Regardless of the price level or the level of interest rates, firms will invest if they are confident about the future (of their company and the economy generally) and will not invest if they are pessimistic. The famous economist, Keynes, was keen on this factor. Whereas monetarists feel that the rate of interest is the main determinant of firms' investment, Keynesians feel that confidence is far more important. It doesn't matter how low the rate of interest is for a firm if they believe that a downturn is around the corner. They simply will not invest.
- The exchange rate: The £ was fairly strong for most of 2000 (or was it just the weakness of the Euro - see the topic on 'Exchange rates' for more detail). This makes UK exports relatively more expensive abroad, and imports into the UK seem relatively cheap. The decline in the demand for UK exports and the increase in demand for foreign imports caused the AD curve to shift to the left, ceteris paribus.
Of course, all of these arguments can be reversed to give reasons why the AD curve might shift to the right.