Aggregate Demand (AD) (DP IB Economics)

Component

Influence on the component

Explanation

Consumption

• Consumer confidence

• The stronger the economy, the higher consumer confidence

  • Consumers feel secure in their jobs and are confident of receiving regular salary payments

  • Consumption increases and saving decreases

• In a weakening or recessionary economy, consumer confidence falls

  • Consumers feel less secure in their jobs

  • Consumption decreases and saving increases

• Interest rates

• A change in the base interest rates will change the level of consumer spending and savings

• If interest rates increase there is a greater incentive to save

  • More saving = less consumption

• If interest rates increase, the monthly repayment on any loan or mortgage increases

  • Higher loan repayments = less consumption

• Wealth

• If consumer wealth increases, then consumption usually increases

• Rising property prices or share prices give consumers confidence to borrow more money

  • Increased borrowing = increased consumption

• Income taxes

• Disposable income is the money that households have left from their salary/wages after they have paid their taxes and have received any transfer payments/benefits

• If taxes increase, then disposable income decreases - and vice versa

• Level of household indebtedness

• Debt is usually repaid with monthly payments

• The higher the level of debt, the higher the monthly repayment and the less money available for new consumption

• Expectations of future price level

• If consumers believe prices will rise in the future, they are incentivised to consume now - and vice versa

Component

Influence on the component

Explanation

Investment

• Interest rates

• Most investment by firms is financed through business loans

• Decreasing interest rates encourage investment

• There is a mostly inverse relationship between investment and interest rates

• Business confidence

• Firms will choose to invest if they feel confident that they will make a good return on their investment

  • The decision to invest is linked to the business objective of profit maximisation

• The longer a period of economic growth, the higher the business confidence will be

  • If growth slows, future expectations of profits will decrease and investment decisions become harder

• Technology

• When a firm identifies new technology which will reduce costs and raise output, they are incentivised to invest

• Business taxes

• When governments raise business taxes it reduces the profits of firms

• Lower profits mean there is less money available for investment

• Level of corporate indebtedness

• Corporate debt is usually repaid with monthly payments

• The higher the level of debt, the higher the monthly repayment and the less money available for new investment

Component

Influence on the component

Explanation

Government spending

• Political priorities

• Governing parties have different political priorities which influence spending

• Some parties believe the state should provide more goods/services and spending increases

• Other parties believe the role of government in society should be smaller and spending decreases

• Economic priorities

• Fiscal Policy is set once a year and announced during the presentation of the Government's budget

• Expenditure is directly related to the Government's objectives and policy aims

  • E.g., A policy aimed at upgrading a country's rail network requires increased expenditure

Component

Influence on the component

Explanation

(Exports - Imports)

• Income of trading partners

• When the household income of trading partners increases, foreigners purchase more products - exports increase

• When the household income of trading partners decreases, foreigners purchase fewer products - exports decrease

• Exchange rates

• When the domestic currency appreciates, consumers' money goes further abroad - imports increase

• When the domestic currency appreciates, exports are more expensive for foreigners - exports decrease

• When the domestic currency depreciates, consumers' money goes less far abroad - imports decrease

• When the domestic currency depreciates, exports are less expensive for foreigners - exports increase

• Trade policies

• If protectionism increases there is decreased demand for imports as they are more expensive

• If protectionism decreases there is increased demand for imports as they are less expensive - and exports usually increase due to free trade