Components of Aggregate Demand
There are four components of Aggregate Demand (AD); Consumption (C), Investment (I), Government Spending (G) and Net Exports (X-M). So,
Consumption: made by households, and sometimes consumption accounts for the larger portion of aggregate demand. An increase in consumption shifts the AD curve to the right.
Factors that affect consumption:
- Consumer Confidence – if consumers are confident about future income, job stability, and the economy is growing and stable, spending is likely to increase. However, job insecurity and uncertainty over income is likely to delay spending. An increase shifts AD to the right.
- Interest Rates – lower interest rates tend to increase consumption because larger goods are usually purchased on credit and if interest rates are low, then its cheaper to borrow. Consumers mostly borrow to buy houses, which is one of the biggest purchases and lower interest rates means lower mortgage payments, so households can spend more on other goods. Some economists argue that lower interest rates also make saving less attractive, but there is no real evidence. So, lower interest rates increase Aggregate Demand.
- Consumer Debt - If a consumer has a lot of debt, he is unlikely to buy more since he would have to pay his debt off first. Low consumer debt increases consumption and aggregate demand.
- Wealth - Wealth are assets held by a household, such as property or stocks. An increase in property is likely increase to consumption.
Investment: is spending by firms on capital, not households. Investment is the most volatile component of AD. An increase in investment shifts AD to the right in the short run and helps improve the quality and quantity of factors of production in the long run.
Factors that affect investment:
- Interest Rates - firms borrow from banks to purchase large capital, and if the interest rate decreases, it makes it cheaper for firms to invest and provides incentive for firms to take risk.
- Business Confidence - if firms are confident about the economy and its future growth, they are more likely to invest.
- Investment Policy – if governments provide incentive for firms to invest, then investment can increase. Incentives such as tax breaks, subsidies, loans at lower interest rates. However, corruption and bureaucracy deters investment.
- National Income - as firms increase output, they would need to invest in new machines. This relationship is known as The Accelerator.
Government Spending: government spending provides a large total of aggregate demand, and an increase in government spending shifts aggregate demand to the right. Government spending is categorized into transfer payments and capital spending. Transfer payments include pensions and unemployment benefits and capital spending is on things like roads, schools and hospitals. Governments spend to increase the consumption of health services, education and to re-distribute income. They may also spend to increase aggregate demand.
Net Exports: Imports are foreign goods bought by consumers domestically, and exports are domestic goods bought abroad. Net exports is the difference between exports and imports, and can be net imports too, if imports are greater than exports. An increase in net exports shifts aggregate demand to the right. The exchange rate and trade policy effect net exports.