04 Aggregate Demand Flashcards
What are the components of aggregate demand (AD)?
C + I + G + X - M
- Consumption (C)
- Investment (I)
- Government Spending (G)
- Net Exports (X - M)
A rise in the price level causes…
a contraction in AD
As fall in the price level causes…
an extension in AD
Define consumption.
Consumer expenditure on goods and services which includes the demand for ‘durables’ and ‘non-durables’.
Define savings.
The part of disposable income that households don’t spend on goods or services over a period of time.
Disposable income.
Households’ net income over a period of time.
Define the interest rate.
The costs of borrowing and the reward from saving.
What the determinants of consumption?
- Level of disposable income
- Interest rates
- Consumer confidence
- Asset prices
- Household indebtedness
- Availability of credit
- Changes in income tax
- Wealth
- Share prices
How would a reduction in unemployment lead to a rise in AD?
- It means that there would be a higher level of disposable income
- Therefore consumers are likely to increase spending (consumption) on goods and services, increasing AD
How is the marginal propensity to consume calcuated?
Change in consumption/change in income
How is the marginal propensity to save calculated?
Change in saving/change in income
Define investment.
Spending by firms on capital goods, used to produce goods and services.
What are the determinants of investment?
- Interest rates
- Business confidence and profits - increased profits - more money for investment in capital goods
- Corporation tax
- Spare capacity
- Level of competition
- Price of capital
- Consumer spending (the accelerator effect)
- Subsidies
- Availability of loans
Why are consumption and investment often positively correlated?
If there is a high level of consumer spending then this will boost investment as:
- Consumption should increase profits for firms
- There should be a boost to business confidence and investment becomes less risky
Define the Accelerator Effect.
When a rise/fall in AD causes a larger percentage rise/fall in investment. This can be positive or negative.
E.g.:
- Economic growth falls by 2%, investment falls by 5%
- Economic growth increases by 5%, investment will rise by more than 5%
Explain the accelerator effect.
In an industry where demand is rising quickly
- Firms may respond initially by using their existing productive capacity more intensively or running down stocks finished products
- If they expect high demand will be sustained - they may increased spending on plant and machinery, factories and new technology in order to increase their supply capacity
- Cause an accelerator effect
What are some examples of the accelerator effect in action?
- Investment to create extra capacity in cloud computing storage services
- Investment in 4G mobile networks to meet rising household and business demand
- Expanding the fleet sizes of growing airlines especially for low-cost short destinations
- Capital investment in renewable energy as the balance of energy supply shift towards renewables
What is the negative accelerator effect?
- When the rate of growth of demand in an industry slows than net investment spending by businesses often often falls
Define government spending.
The sum of all spending by the government.
Define the budget.
The Chancellor’s plans for taxation and government spending over the coming year.
Define budget deficit.
When the government spends more than it received in tax revenue in a given year i.e., G > T.
Define budget surplus
When the govt receives more tax revenue than govt spending in a given year i.e., G < T.
The budget is balanced when…
T = G
Define national debt.
The sum total of all previous debts the government has run up.
How does the government borrow money?
It sells bonds - promise to make payments on a certain date.
Who do the government sell bonds to?
- Individuals
- UK banks and financial institutions
- Foreign Governments, banks and individuals
How does government bond selling work?
- Government sells bond to individuals, banks, foreigners, etc.
- Government use money to finance budget deficit
- Government pays interest to bond holders at an agreed rate of interest in the future
What are the benefits of a budget deficit?
- Stimulates economic growth - G > T
- Higher budget deficit might bring about a positive fiscal multiplier effect - final change in national income bigger than the increase in government spending and borrowing could stimulate private sector investment
- A fiscal stimulus by more can help to prevent an economy falling into a deflationary depression
- A deficit might reflect extra spending on capital projects - new schools, roads - and supply side policies (E.g. cuts in corporation tax) - might increase long run growth
- Long term = larger deficit could be self-financing
Why do Keynesian economists favour the active use of fiscal policy?
- To manage aggregate demand
- Stabilise output
- Confidence and investment after an external economic shock
- Fiscal policy via changes in the budget deficit might be more effective than monetary policy - e.g., if there is a liquidity trap
What is a liquidity trap?
Occurs when a period of very low interest rates and a high amount of cash balances held by households and businesses fails to stimulate aggregate demand.
What are the drawbacks of a budget deficit?
- Adds to national debt thus increases the government’s debt servicing costs - taxes may need to higher
- Might push up long term interest rates and thus crowd out private sector investment - to persuade people to lend it the money needs the government might have to offer higher interest on its bonds
- Excessive government borrowing might lead to an over-heating economy - causes increased demand-pull and cost-push inflation
- Risk of government failure from the state borrowing to pay for increased infrastructure and extra public services
Name the 3 types of government spending.
Transfer spending, current spending and capital spending.
What is transfer spending?
Payments from which the government does not receive anything back from in return e.g., universal credit.
What is current spending?
Day to day spending on state-provided goods and services e.g., NHS and teacher salaries.
What is capital spending?
Includes infrastructure spending such as new roads, hospitals and schools. This investment spending increases an economy’s PPF.
Define net exports.
The revenue gained from exports (X), minus the revenue spent on imports (M).
What are the factories affecting net exports?
- Quality of exports
- Exchange rates (via interest rates)
- Income (in the UK and abroad)
Define the exchange rate.
The value of one currency in terms of another.
What are exchange rates determined by?
- Interest rates
- Relative inflation rate
- Confidence
- Competitiveness
- Rate of growth
- Demand and supply
What does SPICED stand for?
Strong Pound Imports Cheap Exports Dear
What does WPIDEC stand for?
Weak Pound Imports Dear Exports Cheap
What happens when exchange rate rises?
- Export prices increase
- Imported goods cheaper
- Foreign competition more effective in the UK
What happens when exchange rate falls?
- Export prices decrease
- Imported goods more expensive
- Foreign competition less effective in the UK
A rise in interest rates will lead to a fall in…
aggregate demand as they reduce consumer spending and investment - it will reduce spending on imports and will improve the competitiveness of exports.
Why does an increase in interests rates could a rise in the exchange rate.
- Increase in interest rates (UK)
- Rise in Exchange Rate
- X fall, M rises, (X-M) falls AD falls
What is hot money?
Hot money flows refer to capital flows moving to countries with higher interest rates and/or expected changes in exchange rates.
Give an example of the hot money effect.
- Increase in UK interest rates
- Better return on UK saving accounts
- ‘Hot money flows’ in to take advantage of higher interest rates
- Increased demand for £ Sterling
- Appreciation in value of £ Sterling
Explain the impact of a fall in UK income on net exports.
- Fall in income in UK
- UK consumers spend a lot on imports
- UK consumers have less money to spend on imports
- Fewer imports
- Rise in net exports
Explain the impact of a rise in incomes abroad on net exports.
- Foreigners more likely to purchase UK exports due to higher income
- Likely increase in exports
- Rise in net exports
Explain the impact of a fall in quality of imports on net exports.
- Less demand for imports
- Decrease in imports
- Rise in net exports
What it is the only factor that will cause a movement along the AD curve?
Price level (i.e., inflation and deflation).
When do shifts in the AD curve occur?
When there is a change in C, I, G or (X-M).
Chain of analysis:
- How will increased house price impact AD?
- Rise in house price
- Positive wealth effect
- Rise in consumption
- Rise in AD
Chain of analysis:
- How will interest rates rising in the UK from 0.25% to 1% impact AD?
- Rise in D savings in UK banks
- Inflow of ‘hot money’
- Increase D£
- Strong £ (SPICED)
- Rise in M, fall in X
- Fall in AD
Chain of analysis:
- How will decreased incomes abroad coupled with a fall in the quality of UK exports impact AD?
- Fall in D for UK exports
- UK is going to sell fewer exports
- Fall in exports
What will the impact of the government cutting healthcare spending be?
- Fall in G
- Fall in AD
What will the impact of a fall in the sterling exchange rate against other currencies impact be?
- WPIDEC
- X cheaper
- Decrease £D
- Rise in X, fall in M
What will the impact of a rise in the Marginal Propensity to Consume, due to a rise in consumer confidence, be an AD?
- Increase in consumer confidence
- Rise in consumption
- Rise in aggregate demand
Impact on AD if the government decreases the basic % rate of income tax from 20% to 18%
Rise in C therefore rise in AD - could increase the budget deficit.
Impact on AD if there is a sustained fall in the real value of UK property prices.
Fall in AD due to wealth-effect - fall in C.
