Aggregate demand and aggregate supply model

3.Kelements of the model
BasedThe components of aggregate demand are:
C = Consumption (spending by households).
I = Investment (spending by firms).
G = Government spending (spending by the government).
(X-M) = Exports minus imports (the difference between how much we sell and buy foreign goods and services).
It is very important to understand how components of AD change (increase or decrease) because it is likely to lead to a higher or lower aggregate demand.
Let’s look into the four components of aggregate demand in detail.
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Consumption and saving in aggregate demand
Consumption is the total amount of households’ planned spending on goods and services produced in the economy.
Consumer spending is the single largest component of aggregate demand. It made up 60.8% of the nominal GDP (gross domestic product) in June 2021.
The GDP is a quantitative measure that shares the same equation with aggregate demand. You will find more details on this in the Macroeconomic Performance Indicators explanation.
Whenever consumers decide whether or not to spend money on goods and services, they are at the same time deciding whether or not to save. Both consumption and saving are interrelated since a determinant of consumption is also a determinant of household saving.
Saving is the disposable income that is not spent. The process of savings occurs when people decide to postpone their consumption until a future time.
Let’s say Country X has a closed economy. This means they are not exporting nor importing any goods and services. Furthermore, there is no taxation in Country X, meaning that households and firms are not paying taxes to the government. With this in mind, we can assume that households, at any level of income, can either spend it or not. In this scenario, spending their income will result in an increase in consumption, whereas not spending it will result in saving.
Consumption consists of goods with different life spans:
Non-durable goods are consumed in one use or over a short period, e.g. food, petrol, clothes.
Durable goods have a long life span, e.g. automobiles, household appliances, furniture.
There are a variety of determinants that influence consumption and savings:
Interest rates
Availability of credit
Level of real disposable income
Distribution of income
Availability of wealth
Consumer confidence
Interest rates
An interest rate is the reward for saving and the cost of borrowing. It is expressed as a percentage of the money saved or borrowed.
There are various types of interest rates in the economic environment. These include:
Interest rates on savings in the bank and other accounts.
Borrowing interest rates.
Mortgage interest rates (housing loans).
Credit card interest rates and payday loans.
Interest rates on government and corporate bonds.
The interest rate rewards savers for sacrificing their current consumption. The higher the interest rate, the greater the reward will be. Therefore, one could argue that a higher interest rate could lead to lower consumption as households could choose to save to get a higher reward.
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Availability of credit
Interest rates are very closely interlinked with the availability of credit. If more credit becomes available and the interest rate is low (meaning that borrowing is cheap), it could encourage households to spend more by supplementing their income with loans from banks. For example, they may choose to get a mortgage, buy a car or go on vacation.