The four components — and their relative size

• C — Consumption: household spending on goods and services. By far the largest component, around 60–65% of UK AD. Because it is so big, a small % change in C swamps a large % change in I. That is the single most important fact in this topic.
• I — Investment: firms' spending on capital goods — machinery, buildings, vehicles, plus changes in stocks. Roughly 15–18% of AD. Small, but the most volatile component, so it drives much of the trade cycle. Investment is not buying shares — that is a transfer of ownership, not new capital.
• G — Government spending: current and capital spending by the state, around 20–25%. It excludes transfer payments (benefits, pensions) because they are not payments for output — they get counted when the recipient spends them, as C.
• (X − M) — Net trade: exports minus imports. Small in size and typically negative for the UK, which runs a persistent trade deficit — so net trade is a drag on UK AD.

Exam-critical: exports are an injection (foreign spending on UK output, so they add to AD). Imports are a withdrawal (UK spending that leaks abroad, so they subtract). That is why M carries a minus sign.

Your turn — calculate AD

Why does AD slope downwards?

The AD curve plots the price level against real national output. It slopes down — but not for the same reason a microeconomic demand curve does. There are three distinct macro reasons:

• The wealth (real balance) effect. A higher price level reduces the real value of households' money holdings and savings. Feeling poorer, they cut consumption.
• The interest rate effect. A higher price level means people need more money for transactions; demand for money rises, pushing interest rates up. Dearer credit reduces investment and interest-sensitive consumption.
• The international trade (competitiveness) effect. A higher domestic price level makes UK goods dearer relative to foreign goods. Exports fall and imports rise, so (X − M) falls.

Shift or movement — and which way?

Only a change in the price level gives a movement along AD. Everything else shifts it.

What drives consumption?

The dominant influence is disposable income (Yd) — income after direct tax and benefits. Keynes's insight: as disposable income rises, consumption rises, but by less than the rise in income, because some is saved.

• MPC — the marginal propensity to consume = the fraction of each extra pound of disposable income that is spent. MPC = ΔC ÷ ΔYd.
• MPS — the marginal propensity to save = ΔS ÷ ΔYd. In a simple closed economy with no tax, MPC + MPS = 1, because every extra pound is either spent or saved. Saving is simply income not consumed — the two are mirror images.
• The poor have a higher MPC than the rich (they must spend nearly everything they get). This has a powerful policy implication for 2.4: redistributing income towards low earners, or targeting a stimulus at them, produces a bigger multiplier.

Other influences on C:

• Interest rates — higher rates make saving more attractive, borrowing dearer, and raise mortgage payments (cutting the discretionary income of homeowners). All three reduce C, especially for big-ticket, credit-financed items.
• Consumer confidence — expectations about future income and job security. Fear of redundancy raises precautionary saving and cuts C sharply, even before incomes have actually fallen.
• Wealth effects — a rise in house prices or share prices makes households feel richer, so they save less and borrow against the asset. Note the distinction: wealth is a stock; income is a flow. Wealth effects can move C without any change in income at all.

Your turn — the MPC

Your turn — the consumption function

The size of the components

Investment and 'animal spirits'

Gross investment = all spending on capital goods. Net investment = gross investment minus depreciation (the capital that wears out). Only net investment adds to the capital stock and shifts LRAS right. If gross investment merely covers depreciation, the economy is standing still.

Influences on investment:

• The rate of economic growth — the accelerator effect. Firms invest in anticipation of demand, so investment depends on the rate of change of output. A slowdown in growth (not even a fall) can cause investment to collapse. This is why I is so volatile.
• Business expectations and confidence — Keynes's "animal spirits": investment is driven by "a spontaneous urge to action rather than inaction", not by cold calculation, because the future is genuinely uncertain (not merely risky). Confidence can therefore collapse for reasons that have nothing to do with fundamentals — and take investment with it.
• Interest rates — the cost of borrowing and the opportunity cost of using retained profit. Higher rates raise the hurdle a project must clear, so fewer projects are profitable.
• Access to credit — even at a low interest rate, if banks will not lend (as after 2008), investment does not happen. Rates are necessary but not sufficient.
• Demand for exports, corporation tax and regulation, and government incentives (capital allowances, investment zones).

Evaluation: the empirical link between interest rates and investment is weaker than theory suggests. In a deep recession, confidence is so shattered that even near-zero rates fail to revive investment — Keynes's point exactly, and the reason central banks turned to quantitative easing (2.6.2).

Investment

Government spending and net trade

Government spending (G) is influenced by:

• The trade cycle. In a recession, spending on unemployment benefits rises automatically while tax revenue falls. These are automatic stabilisers — they cushion AD without any new decision being taken. In a boom they work in reverse.
• Fiscal policy. A deliberate, discretionary decision to raise or cut spending — expansionary to boost AD, contractionary (austerity) to cut the deficit.

Net trade (X − M) is influenced by:

• Real income at home and abroad. Faster UK growth raises imports (worsening net trade); faster growth in our trading partners raises exports.
• The exchange rate. Remember SPICED: Strong Pound = Imports Cheap, Exports Dear. An appreciation therefore worsens net trade and reduces AD. A depreciation does the opposite.
• The state of the world economy — a global recession destroys export demand.
• Degree of protectionism — tariffs and quotas imposed on UK exports cut X.
• Non-price factors — quality, design, branding, reliability, after-sales service. These matter enormously: German cars sell despite a strong euro because their demand is price-inelastic on quality grounds.

Evaluation of a depreciation: whether it improves net trade depends on elasticities (the Marshall–Lerner condition: PEDx + PEDm > 1) and on time — the J-curve. In the short run, demand is inelastic and contracts are already priced, so the trade balance worsens first before improving.

Match the determinant to its component

Tap a determinant on the left, then the component of AD it drives.

The exchange rate and AD

Judging the strength of an AD shift

The big ideas to know

Press Finish to see your score.