3.2.2.3 - The components of aggregate demand

Spending on domestic output

Aggregate demand is total planned expenditure on domestically produced goods and services at each price level. Its components are consumption $C$, investment $I$, government purchases $G$ and net exports $X-M$:

Consumption is household spending on goods and services. Investment is expenditure on productive capital and inventories, including new machinery, buildings and stocks. Government purchases are public spending on goods and services. Exports are overseas purchases of domestic output; imports are domestic purchases of overseas output. Buying an existing share or saving in a bank is a financial transaction, not the creation of a new capital good counted as investment here.

Imports are subtracted because the other expenditure totals can already include imported products. This subtraction prevents counting foreign production as domestic output; it is not a claim that every import is harmful. An imported machine may raise future domestic capacity even though its overseas value is deducted from current spending on domestic output.

Using illustrative annual amounts in billions of pounds, $C=600$, $I=100$, $G=200$, $X=150$ and $M=170$ give AD of $600+100+200+150-170=£880$ billion. Net exports are $-£20$ billion, so domestic spending exceeds expenditure on domestic output. The identity organises spending; to explain a change, identify which agent changed a decision and why.

Consumption and saving decisions

Households divide disposable income between consumption and saving, the part not consumed. Disposable income is income after direct taxes plus transfers. Higher real disposable income usually allows both consumption and saving to rise. Saving is a flow per period; accumulated savings are part of wealth.

Other determinants change that division. Greater consumer confidence may encourage current purchases and reduce precautionary saving. Fear of unemployment can do the reverse. A rise in house or financial wealth can support spending even without a current income rise. Credit availability allows purchases to be brought forward, while debt repayment commitments can restrain them. Expected future income and prices influence whether households buy now or wait.

A higher interest rate rewards saving and makes borrowing more expensive, tending to discourage credit-financed consumption. The effect is not uniform: savers may receive more interest income, borrowers pay more, and some households may save less to reach a target amount. Inflation that erodes real wealth or purchasing power can also alter behaviour. Explain the relevant household incentives rather than asserting one automatic response for everyone.

For example, if an illustrative household's monthly disposable income rises from £2000 to £2200 while consumption rises from £1800 to £1940, saving rises from £200 to £260. Higher consumption and higher saving can occur together. If many households instead try to save more at unchanged income, lower consumption can reduce firms' sales and national income. The attempted rise in saving need not become an equal rise in total realised saving.

Investment and the accelerator

Firms invest when the expected returns justify the costs and risks. Expected demand, business confidence and existing spare capacity affect whether new machinery is needed. Interest rates and access to finance affect its funding cost. Technology can create profitable opportunities; taxes, subsidies and expected future policy can alter after-tax returns. High profits can provide internal funds, but profitable firms may still postpone investment if sales prospects are weak.