Edexcel IAL Economics: Aggregate demand and its components (YEC11) – Revision Notes

These notes condense section 2.3.2, Aggregate demand (AD), of the Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics specification (YEC11), Issue 2, June 2018. It is Unit 2 content, which the specification places in the International AS (IAS) part of the qualification; Units 3 and 4 are the extra International A2 (IA2) content. For full explanations and worked examples, read the study guide. Test yourself with the practice questions, tick off topics on the checklist, and see the rest of the course on the hub. The free diagnostics show which topics to prioritise. All figures here are invented.

Key definitions

Term	Meaning
Aggregate demand	Total planned spending on a country’s output at a given price level in a given period
Consumption (C)	Household spending on goods and services
Investment (I)	Firms’ spending on capital goods (and stocks)
Government expenditure (G)	State spending on goods and services; excludes transfer payments
Net trade (X−M)	Exports minus imports
Disposable income	Income after direct taxes and plus benefits
Savings ratio	Savings as a percentage of disposable income
Gross investment	Total spending on capital goods
Net investment	Gross investment minus depreciation
Depreciation	Fall in the value of capital through wear and obsolescence

Formulas

Result	Formula
AD	C + I + G + (X−M)
Disposable income	C + S (income is spent or saved)
Savings ratio	savings ÷ disposable income × 100
Net investment	gross investment − depreciation
Change in capital stock (%)	net investment ÷ opening capital stock × 100
Percentage change	change ÷ original × 100
Income elasticity effect	% change in quantity = YED × % change in income
Price elasticity effect	% change in quantity = PED × % change in price (sign: price fall raises quantity)
Post-tax return	pre-tax profit × (1 − tax rate) ÷ cost

The AD curve

• Axes: price level (vertical), real output (horizontal). It slopes down.
• Reasons: wealth effect, interest rate effect, international trade effect.
• Movement along: triggered solely by the general price level changing.
• Shift right: a rise in C, I, G or X−M at every price level. Shift left: a fall.

Quick check. Country with C = 700, I = 120, G = 180, X = 160, M = 190: AD = 700 + 120 + 180 + (160 − 190) = 970.

Consumption: method in steps

Chain for any influence: change in influence, then change in disposable income or willingness to spend, then change in C, then shift in AD, then effect on output, jobs and prices.

Influence	Rise in the influence	Effect on C
Disposable income	More to spend	Rises
Interest rates	Saving rewarded, loans dearer	Falls
Consumer confidence	Less fear of job loss	Rises
Welfare payments	Higher incomes for low earners	Rises
Wealth (house or share prices)	Owners feel richer	Rises
Availability of credit	Easier borrowing	Rises now, debt later

Savings ratio. Example: savings 3,000 on disposable income 50,000 gives 6.0%. Savings 5,000 on 52,000 gives 9.6%, so the ratio rose by 3.6 percentage points.

• Causes of a rise: higher interest rates, low confidence, tighter credit, falling asset prices, ageing population, benefit cuts.
• Effects: lower C and AD in the short run; more funds for lending in the longer run.
• Evaluate with: size of rise, spare capacity, whether banks lend the savings, whether firms want to borrow, how long it lasts.

Investment: must-know distinctions

Gross	Net
All new capital spending	Gross minus depreciation
Can be positive while capacity falls	Only positive net investment raises capacity

Example: gross 80, depreciation 50, net = 30. If gross were 40, net = −10 and the capital stock shrinks.

Influences: growth (firms need capacity; the pace of growth matters), interest rates, business confidence and expectations, availability of credit, tax on company profits.

Policy to promote I:

Tool	How it works	Main weakness
Tax relief	Lets firms offset spending against tax	Costs revenue; some would have invested anyway
Subsidy	Cuts project cost directly	Government may pick poorly; costly
Lower corporation tax	Raises post-tax return	Only helps profitable firms; slow

Method for a hurdle-rate question: post-tax return = pre-tax profit × (1 − t) ÷ cost, then compare with the borrowing rate. Example: profit 60,000 on cost 500,000 is 12.0% pre-tax; at 30% tax, 8.4%; at 20% tax, 9.6%. A firm borrowing at 9% invests only under the lower rate.

Government expenditure: four influences

1. Fiscal policy (deliberate choices)
2. Level of economic activity (automatic stabilisers: benefits up, taxes down in a downturn)
3. Correction of market failures (public goods, merit goods, externalities)
4. Political priorities

Remember: benefits are transfers, not part of G, but they support C.

Net trade: method in steps

1. Say which component moves (X, M or both).
2. Give the reason: income, price, global conditions, trade barriers or quality.
3. State the effect on X − M and so on AD.
4. Qualify with elasticity, time lags or retaliation.

Factor	Effect on X − M
Domestic real income rises	M rises, X−M falls
Foreign real income rises	X rises, X−M rises
Exchange rate falls	Exports cheaper abroad, imports dearer; effect depends on elasticities
World slowdown	X falls
Higher tariffs by partners	X falls
Higher tariffs at home	M falls, but retaliation risk
Better quality, design, reliability, branding	Demand rises at any price

Reminder calculation. Exports 600, imports 700. Foreign income +3% with income elasticity of demand for exports 2.0: exports +6% = 636. Home income +2% with income elasticity for imports 1.5: imports +3% = 721. Balance moves from −100 to −85.

Evaluation prompts to reuse

• Size and share: how large is the component in AD? A 5% fall in a component that is 60% of AD matters more than a 10% fall in one that is 20%.
• Spare capacity: a rise in AD lifts output when there is slack, and prices when there is not.
• Time lags: investment decisions and trade responses take months or years, so the short run can differ from the long run.
• Elasticity: the price and income elasticities of exports and imports decide how far net trade changes.
• Expectations: confidence can reinforce or cancel a policy. A tax cut that firms expect to be reversed may not change plans.
• Cost to government: tax relief, subsidies and extra spending all reduce revenue or raise the deficit.
• Other components: a fall in one component can pull others down, because lower output cuts incomes and profits.

End each evaluation with a verdict and say what would change it.

Must-know distinctions

• Movement along AD (price level) versus shift (anything else).
• Gross versus net investment.
• Savings (a flow) versus the savings ratio (a proportion of income).
• Transfers (not in G) versus government spending on output.
• Income effect on imports versus price effect of a currency change.

Quick self-test

1. State the AD formula.
2. A country has C = 400, I = 90, G = 130, X = 110, M = 140. Calculate AD.
3. Give two things that cause a shift of AD to the left.
4. Disposable income is 20,000 and savings are 1,400. Calculate the savings ratio.
5. Gross investment is 70 and depreciation is 45. Calculate net investment.
6. Give two influences on investment.
7. A project costing 200,000 earns 24,000 profit before tax. Calculate the post-tax return at 25% tax.
8. Name two tools to promote investment.
9. Why do rising house prices raise consumption?
10. Give two non-price factors that raise exports.
11. Imports are 500 and income elasticity of demand for imports is 2.0. Home income rises 4%. Calculate the new level of imports.
12. State one reason why a rise in the savings ratio may be good for investment.

Answers

1. AD = C + I + G + (X−M).
2. 400 + 90 + 130 + (110 − 140) = 590.
3. For example, a fall in consumer confidence; a rise in interest rates; cuts in G; a world slowdown.
4. 1,400 ÷ 20,000 × 100 = 7.0%.
5. 70 − 45 = 25.
6. For example, interest rates and business confidence (or growth, credit availability, tax on profits).
7. 24,000 × 0.75 = 18,000; 18,000 ÷ 200,000 = 9.0%.
8. For example, tax relief and subsidies (or lower corporation tax).
9. Owners feel wealthier, and can borrow against property, so they spend more.
10. For example, quality and reliability (or design, branding, after-sales service).
11. Imports rise 2.0 × 4 = 8%; 500 × 1.08 = 540.
12. More savings can be lent by banks to firms, which can lower interest rates and fund projects.

Where marks are usually lost

• Drawing the AD curve and shifting it when the cause was a change in the price level.
• Describing an influence without linking it to AD.
• Treating a rise in savings as only bad (or only good) with no evaluation.
• Mixing up gross and net investment, or forgetting depreciation.
• Applying the wrong sign when an exchange rate falls (the home price of imports rises).
• Quoting a percentage-point change as a percentage change.
• Evaluating with a list of generic “it depends” phrases rather than a named factor such as spare capacity or elasticity.
• Leaving out the diagram’s axis labels.

Official syllabus

Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics, Specification, Issue 2, June 2018, Pearson Education Limited. Section 2.3.2, Aggregate demand (AD).