Pearson Edexcel International Advanced Level Economics: Aggregate demand and its components (YEC11)

This guide covers 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 sits in Unit 2, Macroeconomic performance and policy. The specification labels Units 1 and 2 as the International AS (IAS) units and Units 3 and 4 as the International A2 (IA2) units, the additional content required for the full International Advanced Level. This topic is IAS content and is also part of the full qualification.

Every figure below is invented, and the countries named (A, B and C) are fictional, each label used for one economy only. Pair this guide with the revision notes and the practice questions. The course hub and the printable checklist show where this topic fits, and the free diagnostics help you find weak spots. For growth, see the economic growth guide.

What the specification asks for

Item	What you must be able to do
1 Characteristics of AD	Explain the concept of AD; set out C + I + G + (X−M) and the AD curve; separate a movement along the curve from a shift
2 Consumption (C)	Explain six influences; link savings and consumption; define the savings ratio; analyse its causes and effects
3 Investment (I)	Separate gross and net investment; explain five influences; evaluate tax relief, subsidies and lower corporation tax
4 Government expenditure (G)	Explain four influences: fiscal policy, the level of economic activity, correction of market failures, political priorities
5 Net trade (X−M)	Analyse the effect of real income, the exchange rate, the global economy, protectionism and non-price factors

1 Characteristics of AD

Aggregate demand is the total planned spending on a country’s output of goods and services at a given price level in a given period. It is the sum of four components:

AD = C + I + G + (X − M)

C is household consumption, I is investment by firms, G is government spending on goods and services, and X − M is exports minus imports, the net trade balance. Welfare benefits and other transfer payments sit outside G, since the state buys no output with them. They reach AD only indirectly, by changing household income and so C.

Worked example 1. Country A (illustrative, billions of units of currency): C = 620, I = 150, G = 210, X = 180, M = 200.

• Net trade = 180 − 200 = −20
• AD = 620 + 150 + 210 + (−20) = 960
• Shares of AD: C = 620/960 = 64.6%, G = 210/960 = 21.9%
• If exports rise by 20: AD = 980, a rise of 20/960 = 2.08%

The AD curve. AD slopes downward. On its diagram the vertical axis shows the price level and the horizontal axis shows real output (real GDP). The usual explanations are a wealth effect (higher prices cut the real value of savings), an interest rate effect (higher prices raise interest rates and cut spending on credit) and an international effect (higher domestic prices make exports dearer and imports cheaper).

Movement versus shift. Only a change in the general price level slides you along the existing curve. Any other change in C, I, G or X − M relocates the whole curve.

Price level	Real output demanded (before)	After a confidence boost
90	1,040	1,080
100	1,000	1,040
110	960	1,000
120	920	960

A rise in the price level from 100 to 110 moves you from 1,000 to 960 on the first column. The confidence boost adds 40 at every price level, so the curve shifts right.

2 Consumption (C)

Influences on C (2.3.2 item 2a). Each needs a chain of reasoning:

• Disposable income is income after direct taxes and plus benefits. More disposable income raises C.
• Interest rates. Higher rates reward saving and raise the cost of borrowing, so C falls. Households with variable-rate debt feel an immediate fall in spendable income.
• Consumer confidence. If households expect secure jobs and rising incomes, they spend more and save less.
• Level of welfare payments. Higher benefits raise the disposable income of low-income households, who tend to spend most of it.
• Wealth effects. Rising house or share prices make owners feel richer and more able to borrow against assets, so C rises. Falling prices do the opposite.
• Availability of credit. Easier lending raises C now, but may leave households with debt to repay later.

Worked example 2 (interest rates). A household has 30,000 of income after tax and before mortgage interest, and a variable-rate loan of 150,000.

• Interest at 4%: 150,000 × 0.04 = 6,000
• Interest at 5%: 150,000 × 0.05 = 7,500
• Extra cost = 1,500, which is 1,500/30,000 = 5.0% of that income

The household’s spending power falls before any effect on saving. Across many indebted households, C and so AD fall.

Savings and consumption (item 2b). Disposable income is either spent or saved: Yd = C + S. So a rise in saving is a fall in consumption unless income rises by enough.

The savings ratio (item 2c). The savings ratio is savings as a percentage of disposable income:

savings ratio = (savings ÷ disposable income) × 100

Worked example 3. Households in Country B (illustrative): Year 1 disposable income 40,000 and savings 2,800; Year 2 disposable income 42,000 and savings 4,200.

• Year 1 ratio = 2,800/40,000 × 100 = 7.0%. Consumption = 37,200
• Year 2 ratio = 4,200/42,000 × 100 = 10.0%. Consumption = 37,800
• Income grew by 5.0%, but consumption grew by only 600/37,200 = 1.61%
• Consumption’s share of income fell from 93% to 90%

Causes of a higher ratio (item 2d): higher interest rates, falling confidence or fear of job loss, tighter credit, falling asset prices that households try to offset by saving, an older population saving for retirement, and cuts to benefits.

Effects of a higher ratio:

• Short run: lower C, so lower AD, lower output and fewer jobs. Firms’ revenue falls.
• Longer run: more funds for banks to lend, which can lower interest rates and support I.
• Evaluation: the effect depends on how big the rise is, whether the economy has spare capacity, whether savings are lent on to firms (and firms want to borrow), and how long the change lasts. A rise in saving for a stretch of years during a recession may deepen it.

3 Investment (I)

Gross and net investment (item 3a). Gross investment is total spending on capital goods. Net investment is gross investment minus depreciation (the wearing out of existing capital).

Worked example 4. Country A: gross investment 150, depreciation 90, capital stock at start of year 1,800.

• Net investment = 150 − 90 = 60
• New capital stock = 1,860, an increase of 60/1,800 = 3.33%

If gross investment were below depreciation, net investment would be negative and the capital stock would shrink. Only net investment raises productive capacity.

Influences on I (item 3b):

• Rate of economic growth. Faster growth means firms need more capacity. Investment responds to the rate of change of output, not only its level.
• Interest rates. They set the cost of borrowing and the return on keeping money in a bank instead.
• Business confidence and expectations. Investment is spending now on uncertain future profit.
• Availability of credit. Firms without access to loans cannot fund projects.
• Tax on company profits. Lower tax raises the return after tax.

Worked example 5 (growth). A simplified illustration assumes firms need 3 units of capital per unit of output.

Year	Output	Capital needed	Net investment
1	1,000	3,000
2	1,050	3,150	150
3	1,080	3,240	90

Output still grows in year 3 (2.86%, down from 5.0%) but net investment falls by 40%. A slowdown in growth can reduce investment even while output rises.

Worked example 6 (profit tax and interest rates). A project costs 1,000,000 and is expected to add 90,000 of profit a year before tax, a return of 9.0%. The firm can borrow at 7%. (Ignore depreciation and the tax treatment of interest.)

• Corporation tax 25%: profit after tax = 67,500, return 6.75%, below 7%, so the firm does not invest.
• Corporation tax 20%: profit after tax = 72,000, return 7.2%, above 7%, so the firm invests.

Policy to promote investment (item 3c). The three listed tools are tax relief (for example allowing part of the cost of equipment to be set against tax), subsidies (direct payments that lower a project’s cost) and cuts in the corporation tax rate.

Evaluation points: all cost government revenue; some firms would have invested anyway (deadweight); effects take time; if firms are pessimistic or have spare capacity, lower costs may not persuade them; subsidies need the government to choose well; a lower rate of corporation tax helps only firms making profits.

4 Government expenditure (G)

The specification lists four influences on G (item 4a):

• Fiscal policy. Deliberate decisions on spending and taxes. A government wanting to raise AD may increase G.
• The level of economic activity. In a recession, falling tax revenue and rising benefit claims raise the deficit without any new decision; in a boom the reverse. These are automatic stabilisers.
• Correction of market failure. Public goods, merit goods and externalities are often funded by the state.
• Political priorities. A government’s aims (health, defence, tax cuts) shape what it spends.

Worked example 7. Unemployment in a fictional country rises by 150,000 and each claimant receives 4,800 a year.

• Extra benefit spending = 150,000 × 4,800 = 720 million
• If tax receipts also fall by 400 million, the budget moves by 720 + 400 = 1,120 million towards deficit
• Benefits are transfers, so G itself is unchanged, but they cushion C.

Evaluation: a government constrained by debt may be unable to let spending rise in a recession.

5 Net trade balance (X − M)

Real income (item 5a). Higher domestic income raises imports. Higher incomes abroad raise exports.

Worked example 8. Baseline (millions of currency, illustrative): exports 5.0, imports 4.0, balance +1.0. Income elasticity of demand for imports is 1.8 and for exports 2.0.

• Domestic income +3%: imports rise 3 × 1.8 = 5.4%, to 4.216
• Foreign income +1%: exports rise 1 × 2.0 = 2.0%, to 5.1
• New balance = 5.1 − 4.216 = +0.884, so the surplus narrows by 0.116

Exchange rate. A lower exchange rate cuts the foreign-currency price of exports and raises the home-currency price of imports. Whether X − M improves depends on price elasticities.

Worked example 9. Country C’s currency falls from 2.00 to 1.60 foreign units per unit of home currency. Exports: 10,000 units at 500 of home currency. Imports: 20,000 units, priced 400 foreign units.

• Export price abroad: 1,000 → 800 foreign units, a 20% fall. Price elasticity of demand for exports 1.5: quantity rises 30% to 13,000. Revenue = 13,000 × 500 = 6.5 million (was 5.0).
• Import price at home: 400/2.00 = 200 → 400/1.60 = 250, a 25% rise. Price elasticity of demand for imports 0.6: quantity falls 15% to 17,000. Spending = 17,000 × 250 = 4.25 million (was 4.0).
• Balance: 5.0 − 4.0 = +1.0 before; 6.5 − 4.25 = +2.25 after

Here AD rises. With low elasticities the improvement could be small or negative, and imported inputs would raise costs.

State of the global economy. A boom abroad raises demand for exports; a world slowdown cuts it. An open economy is more exposed.

Protectionism. Tariffs, quotas and subsidies to domestic firms. If a partner raises tariffs on your exports, X falls. If you raise them, M falls but you may face retaliation and higher prices.

Non-price factors. Quality, design, reliability, after-sales service, branding, delivery times and marketing affect demand at any given price.

Common errors

• Calling a change in the price level a shift of the AD curve.
• Including welfare benefits in G.
• Writing “gross investment” when you mean net investment.
• Saying a depreciation always improves the trade balance; elasticities decide.

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).