Aggregate demand and supply
Aggregate demand (AD) for goods and services in Australia’s economy represents the total expenditure on the goods and services produced in the economy over a period of time.
If an economy had zero savings, no tax and no trade with the rest of the world (as in the simple circular flow of income shown on the previous page), then AD would equate to the total expenditure on goods and services by consumers. In other words:
AD = C
where C = Consumption expenditure or Consumption demand which is defined as the total value of all expenditures on individual and collective consumption by resident households and non-profit institutions serving households. It includes spending such as on consumer durables (e.g. cars and furniture), semi-durables (e.g. clothes), single-use goods (e.g. food) and services (e.g. hairdressing).
However, like most economies, Australians do save some of their income, they do pay taxes to governments and they do trade with foreigners. As we discovered earlier, these leakages are offset over time by the injections in the form of Investment, Government and Export demand. AD in the Australian economy must therefore include the injections and it becomes:
AD = C + I + G + X – M
I= Private Investment Expenditure which is defined as the purchase of new equipment and plant, buildings and vehicles. The purpose of Investment expenditure is to increase the ability of firms to produce goods and services. It also includes stock purchased by firms and new housing by households.
G = Government Expenditure which includes all demand for goods and services by Federal, State and Local Governments.
[Government expenditure in the Australian economy is often separated into two components - G1 and G2. G1 represents Government Consumption expenditure on goods and services that are not 'capital' in nature (e.g. money spent on the provision of government services provided free of charge, such as payment of government employees, stationery, rent, etc). G2 represents Government Investment expenditure on goods that are of a capital nature (e.g. buildings, infrastructure etc.). The distinction between the two types of expenditure is similar to the distinction between C and I, where Consumption spending technically does not contribute to benefits into future as they are ‘consumed’ in the short term. In contrast, Investment contributes to economic benefits in the future.]
X-M = Net Exports (Exports minus Imports) because exports are Australian-made goods and services that have been purchased by overseas residents, and imports are foreign-made goods and services that are purchased by Australian residents. Imports are subtracted from the AD equation because they are counted in each of the other sections already. When a new aeroplane is purchased by Qantas for example, it will be recorded in the Investment section of AD. Because AD represents the value of spending that has occurred on Australian production, the cost of importing the plane will need to be deducted, because most of the purchase price has been devoted to production that occurred overseas. To include imports in the calculation of AD would overestimate Australian production levels and suggest that economic activity is bigger than it really is!
The relationship between the flows of money in the economy and AD is depicted in the diagram below. It highlights the nature of AD, which is made up by combining the four red components (C + I + G + X) and subtracting M.
Aggregate Supply (AS) of goods and services represents the total volume of goods and services that producers are prepared to supply to the market. It represents the ability of an economy to make available the goods and services to meet AD. A nation’s Aggregate Supply is closely related to the productive capacity of the economy such that any improvement to the supply potential of the economy (i.e. Aggregate Supply) will boost productive capacity and enable AD to be satisfied with minimal impact on inflation or the external sector. This means that increases in AD will only lead to growth in the production of goods and services if the economy has sufficient productive capacity (or Aggregate Supply) to meet that demand. If, for example, Aggregate Supply levels are limited or stretched because of excessive demands placed on our productive resources, then growth in AD cannot be fully satisfied. Limited productive capacity will therefore restrain the rate of economic growth.