Aggregate demand and aggregate supply model

4.Aggregate Demand
On the flip side, higher interest rates would increase the cost of borrowing, and more households would not be inclined to borrow money from the bank on credit. This could lead to a reduction in overall consumption.
Level of real disposable income
The level of income is perhaps the most important reason for choosing whether to spend or save. Income can be real and disposable. Real income refers to the income adjusted for changes in price levels. Disposable income is the income after all the fixed expenses have been deducted from the paycheck.
If a person earns ‘x’ amount per month, they will need to pay income tax, their national insurance contribution, student loans (if they have them), pension contribution, council tax, rent or mortgage, and so on.
Disposable income is what the person has left when they have paid all those fixed commitments.
Imagine that last year that person could go shopping for groceries and got themselves some new clothes. However, this year the price level increased by 5% and their paycheck remained the same.
That means that the real value of that person’s income has decreased because they are now able to afford less than they were the year before.
British economist John Maynard Keynes proposed a theory of a relationship between income and consumption. He stated that consumption will rise but at a slower rate than the income increase as people will not spend all of the money but also save some.
Furthermore, as people become more affluent, they may become less inclined to spend money on meaningless things, but rather save it to build and maintain their wealth. Keynes argued that such a change in spending mentality was a likely cause of economic crises, particularly, the Great Depression in the 1930s: too much saving, not enough spending.
Referring to the Circular Flow of Income model, there were too many leakages and too few injections into the economy.
Distribution of income and wealth
Distribution of income refers to the wealth balance between the more and less affluent people in the economy, i.e. the so-called rich and poor divide. People with different incomes have different spending habits.
Even though it may seem like it is still spending money, what matters is the purpose. Spending for a new item or spending in order to grow wealth affect different components of aggregate demand.
For example, buying a new car would stimulate C, whilst buying foreign currency would stimulate (X - M).
The government can also regulate the distribution of income by introducing an effective tax system. At the moment, the UK operates a progressive tax system. A progressive system imposes higher rates on higher-income earners as opposed to those on a lower income.
Such a system aims to control how burdensome would the tax be onto the earner and adjust as the income rises or falls. This is done to continue the inflow of money into the government budget, but also to try and equalize the impact on a person’s disposable income by making it proportional to the size of their earnings. The idea is that it is fairer for the bigger earners to carry a heavier tax burden. However, the more tax people need to pay, the less likely they will be to spend money on goods and services, which ultimately affects aggregate demand.
To learn more about different tax rates and allowances in the UK check our explanation on Taxation.
As we already mentioned, the amount of personal wealth a household possesses in addition to their flow of income influences the decisions they make on consumption and savings.
A house is one of the main forms of wealth assets one can own. Rising house prices encourage people to consider becoming homeowners because that could open a door for them to start or continue further building their wealth. Once decided to buy a house, a household may temporarily reduce their consumption to save as much as possible for the deposit on a mortgage. That could impact aggregate demand through a decrease in the C component. However, after the purchase, people may need to buy furniture and do a bit of decorating, which would boost their consumption. They may also see a rise in confidence in their financial future and reduce their saving rate.
For property owners, rising house prices induces a ‘feel-good’ factor as it has the effect of increasing consumer spending sprees. However, as housing prices fall, they have the opposite effect of a ‘feel-bad’ factor as more consumers would take a more precautionary role and start saving more. Such a move would affect the consumer expenditure component in the AD leading to its likely decrease.
Another type of asset that increases wealth is having shares in a firm or in an index. If share prices were to increase, share-owners would be wealthier. They could finance more consumption from the increase in dividends from having shares or from using borrowed funds.
On the flip side, falling stock prices or even a stock market crash would have the opposite effect, as it would reduce the value of the ownership the shareholder has in the company. This could lead to a reduction in overall consumption as the shareholder has recorded a loss in wealth, which could lead to decreases in AD.
Consumer confidence
Consumer confidence is largely dependent on the households’ views on their expected income as well as the changes in their personal wealth. When household optimism rises, the amount of spending on goods and services increases and savings decrease. Conversely, when household optimism decreases, the amount of spending on goods and services will decrease and savings increase.
Just before the first lockdown due to the Covid-19 pandemic was announced people thought they needed a large stock of supplies to survive and started panic buying essential items such as canned food, toilet paper, water, and so on. Such a rapid increase in consumption could have negatively affected the economy if the suppliers were not able to adjust supply in the short run to meet such a demand. In the short run, it could have caused a serious shortage and even a rapid surge in prices.
Personal savings ratio and households savings ratio
The personal savings ratio measures the realised savings of the personal sector as a ratio of the total personal disposable income. This can be realised and shown in a mathematical equation:
The household saving ratio is similar; this particular ratio only measures the household realised saving ratio as a ratio to their disposable income. It is important to realise that the personal sector includes unincorporated businesses such as partnerships or charitable organisations.
This savings ratio is important for economists and economic agents in the government as they wish to understand how much money people are willing and able to save as it could have an effect on the state of the aggregate demand.
Investment in aggregate demand
Investment is spending on capital goods such as factories, plants and machinery, buildings, new technology, and vehicles. Investment is essentially the planned demand for capital goods needed for the production of other goods and services. Firms, for example, can invest in new machinery to produce their goods and services, and governments, for example, can invest in human capital.
Unlike capital, which is characterized as a stock concept, investment is a flow concept. This means, for example, that for capital, we can measure the amount of stock available at a given point in time (it is essentially measuring the total of all capital goods of a nation that are still in production). The flow of investment is usually measured over some time, over one year.
A country usually has two types of investment:
Replacement investment. In this form of investment, the country chooses to keep the existing amount of capital and replace the capital that is worn out, such as replacing a machine that doesn’t work anymore.
Net investment. In this form of investment, the country chooses to add to the capital stock, such as investing in new machinery and factories, to increase production potential.
Both the net investment and the replacement investment make up the country’s gross investment.
Note that investment in the context of understanding aggregate demand should not be confused with the concept of investment in financial markets. In the context of aggregate demand investments solely refer to the planned spendings that firms make on capital goods such as machinery, factories, and other long-term assets. Don’t confuse it with the investments in the stock market.
Factors influencing investment decisions
Investment can be classified into two types of physical capital goods: