Aggregate demand and the circular flow of income

AD = Consumption+Investment+Government spending+Exports-Imports

Components of AD

• If the value of any of these components change then AD changes

• Households - consumption
• Firms - investment
• Government sector - Gov. spending and exports & imports

The factors that determine household consumption also determine household saving

When consumption rises - saving falls

Determinants of consumption and saving:

• Interest rates - the amount saved increases as the real rate of interest rises and the amount spent on consumption falls
• The level of income - Consumption rises as income increases - It generally rises at a slower rate than income - households save more as their income increases
• Expected future income - Optimism of the future to do with income - If you think your income is going to increase then consumption will increase - MOOD
• Wealth - when household wealth increases - consumption up, saving down
• Consumer confidence - Confidence increases - spend more, save less - optimism
• The availability of credit - when credit becomes easy to obtain, consumption increases as people supplement current income by borrowing on credit created by the banking system

Total planned spending my firms on capital goods, such as plant, machinery and raw materials

Determinants of investment:

• The rate of interest - the cost of borrowing - firms invest more as the rate of interest falls - it becomes cheaper to raise the funds to fianance investment in new capital goods
• Business confidence - Investment increases as business confidence grows
• Techinal progress - existing machinery will eventually become obsolete or out-of-date - firms invest in new capital to replace old
• The relative prices of capital and labour - when wages rise relative to the price of capital, firms tend to adopt more capital-intensive techonolgies - replacing labout with capital
• The accelerator - a firm produing at full capacity has to invest in extra capacity in order to meet higher future demand for its output - the accelerator is the number that links the change in output to the extra capital needed to produce the additional output

A source of AD  in the economy and - through taxation - the government is also responsible for a major leakage of spending out of the circular flow of income.
The net effect of government spending on AD depends on the nature of the government's budget:

• A budget defecit (G>T) when government spending is greater than tax revenue - represents expansionary fiscal policy with the government injecting spending and demand into the economy
• A budget surplus (G
  
  

Spending on UK exports by residents of other countries is an injection of spending into the UK economy and increases AD.
BUT, spending by UK residents on imports produced in other countries is a leakage of spending - decreases AD

The circular flow of income (diagram)

If the 3 leakages of spending out of the circular flow of income exactly equal the 3 injections, the economy is in a state of macro-economic equilibrium.
BUT, if leakages exceed injections or vise versa, there is a macroeconomic disequilibrium

The multiplier

• measures relationship between an intial change in a component of AD (gov. spending) and the resulting change in the level of national income
• 
• Because the total amount by which income and output increases is a multiplier of the intial increase in spending, the process is known as the multiplier process

Example
If the size of the multiplier is 5, and increase in consumption spending of £10 billion causes national income to rise by £50 billion