1.2 + 1.5 AD + Multiplyer & Accelerator

Question 1

What parts of the spec do these flash cards cover ?

Answer 1

Question 2

What is aggregate demand and what are its components?

Answer 2

Aggregate demand is the total spending on domestically produced goods and services in an economy over a given period of time
- Consumption (C): total spending by households on goods and services in an economy over a given period of time
- Investment(I): total spending by firms on capital goods in an economy over a given period of time
- Government expenditure(G): total spending by the government on goods and services over a given period of time
- Net exports(X-M): total export revenue minus total expenditure on imports

Question 3

What is the biggest determinant of consumption ?

Answer 3

• Consumption is the largest component of AD
• The most important determinant of consumption is disposable income, income after direct taxes, NOT discretionary income

Question 4

What is the Average propensity to consume ?

Answer 4

the average propensity to consume (APC) is the ratio of consumption (C) to disposable income (Y)

APC = C/Y

Question 5

What is the marginal propensity to consume ?

Answer 5

marginal propensity to consume (MPC) is the change in consumption resulting from a change in disposable income

MPC = ΔC/ΔY

Question 6

What is Marginal propensity to save

Answer 6

marginal propensity to save is a change in the fraction of income you save resulting from a change in income

MPS = ΔS/ΔY

Question 7

How does the multiplier effect come about ?

Answer 7

1) An injection into the circular flow of income increases the income received by households
2) Households save a proportion of this and consume the rest
3) firms increase their output in response, therefore paying their FOP (owned by households) more
4) This increases income flowing back to households leading to increased consumption
5) final Δ in national income > initial injection

Question 8

How to calculate the multiplier ?

Answer 8

Multiplier = 1/(1-MPC) = 1/MPW

MPC + MPW = 1

Question 9

What are the other determinants of consumption?

Answer 9

1) Wealth
2) Consumer confidence
3) rate of interest
4) Inflationary expectations
5) Age composition of Households

Question 10

How does wealth affect consumption

Answer 10

• Wealth is the value of stock assets a household has at a given time. An increase in the value of these assets leads to the household becoming wealthier leading to an increase in consumption

Question 11

How does consumer confidence affect consumption ?

Answer 11

If consumers expect their economic situation to remain the same or improve they will tend to spend the same or more on goods and services. Consumer confidence increases during periods of economic growth and decreases during periods of recession

Question 12

How does the rate of interest affect consumption ?

Answer 12

Consumer usually borrow to finance large purchases e.g house, car. An increase in the interest rate means that the cost of borrowing money is greater due to higher monthly repayments on these goods, this reduces disposable income left for consumption. Increase interest rate also leads to increase reward for saving. Thus, an increase in the rate of interest leads to lower consumption

Question 13

How does Inflation expectations affect consumption ?

Answer 13

If consumers expect the price level to rise in the future, they will likely bring forward their purchases due to the purchasing power of their income decreasing in the future. This leads to higher consumption and lower saving. However a higher price level decreases the value of wealth and might encourage more saving

Question 14

How does age composition of households affect consumption ?

Answer 14

The young and old tend to spend a higher proportion of their income. The young may take on debt to finance mortgages whereas the old are usually trying to spend their stock of savings. Thus an economy with a larger proportion of young and old households will tend to see higher consumption

Question 15

What is investment ?

Answer 15

Investment is the addition to the physical capital stock of the economy (factories, machinery, stocks of material) which is then used to produce other goods and services

Question 16

What is gross and net investment ?

Answer 16

• gross investment is the total amount that the economy spends on new capital
• Net investment = Gross investment - Depreciation
• where depreciation is the reduction in the value of existing capital

Question 17

How does the interest rate affect investment?

Answer 17

• Firms finance investment by borrowing or by using retained profits
• if the interest rate goes up, it becomes more expensive for firms to borrow, and certain investment projects are no longer profitable.
• Thus, investment is negatively related to the rate of interest

Question 18

What are the other determinants of investment ?

Answer 18

1) real disposable income
2) business expectations and confidence
3) retained profits
4) access to credit
5) corporation tax
6) the world economy
7) government

Question 19

How does real disposable income affect investment ?

Answer 19

• if the economy is expanding consumers are spending more on goods and services produced by firms, thus firms will have to invest more so that they have the capital equipment needed to match their output to demand.

the link between income and investment is called the accelerator theory

Question 20

How does business expectations and confidence affect investment ?

Answer 20

• if firms expect their sales to increase, they tend to invest more in capital goods to increase output.
• if there is low confidence in the economy investment is likely going to decrease

Question 21

How does retained profits affect investment ?

Answer 21

• this is profits kept by firms. If retained profits are high investment will also likely be high since firms do not have to rely on financing investment as much.

Question 22

How does access to credit affect investment ?

Answer 22

• if banks are willing to lend at lower interest rates, investment is likely to increase since the cost of borrowing to firms is less
• also if there is a well-developed financial sector investment is likely to increase

Question 23

How does corporation tax affect investment ?

Answer 23

• if the corporation tax rate increases, firms are left with lower retained profits, thus they are able to invest less

Question 24

How does the world economy affect investment ?

Answer 24

• if there is a recession in countries that we trade with, there will be a decline in exports, this leads to lower retained profits for firms, thus firms will have to reduce investment.

Question 25

What is the accelerator effect ?

Answer 25

the ‘accelerator’ effect is when an increase in the rate of growth of real GDP can lead to a larger than proportional increase in investment, further accelerating increases in national income

I = a(Yt - Yt-1)

Question 26

What is the basic idea of the accelerator ?

Answer 26

1) when the economy is growing, firms will increase spending on new capital to match increased demand. There is both induced and replacement investment
2) if real GDP is increasing, but the rate is slowing, firms will reduce induced investment, while still undertaking replacement.
3) if real GDP is constant (no growth), investment will be limited to replacement investment
4) if real GDP falls, investment can stop all together

Question 27

What are the 2 types of investment ?

Answer 27

1) induced investment, where firms invest to purchase new capital to produce goods and services
2) replacement investment, where firms invest to replace worn-out capital

Question 28

How to evaluate the accelerator ?

Answer 28

In reality, the accelerator effect is extremely difficult to predict:
- firms may have spare capacity and existing stocks to meet additional demand without increasing investment
- the willingness of firms to invest also depends on confidence in future demand.
- many other factors affect investment decisions e.g cost of financing
- even if firms decide to increase investment, the firms producing the capital goods may not be able to respond to changing demand quickly.

Question 29

What is the difference between government spending and government expenditure ?

Answer 29

Government spending does not include transfer payments where as government expenditure does

Question 30

What factors influence government spending ?

Answer 30

• political considerations (election promises) and policy objectives
• previous commitments to spending
• overall economic activity and the amount of tax revenue generated
• the amount the government is prepared to borrow

Question 31

What are exports and imports ?

Answer 31

exports - total spending on domestically produced goods and services by foreign households, firms and governments
imports - total spending on foreign produced goods and services by domestic, households, firms and government

Question 32

What are the determinants of net exports pt1?

Answer 32

real disposable income in the domestic economy: if the economy is doing well, households will spend more on goods and services, and part of this will be spent on exports
real disposable income in foreign economies similarly, part of foreign consumption is goods produced in the domestic economy. If our trading partners economies are doing well, our exports will go up
the price level in the domestic economy: higher prices makes domestic goods less competitive abroad.

Question 33

What are the determinants of net exports pt2 ?

Answer 33

relative inflation rates in the 2 countries
the exchange rates a rise in the value of the pound means it becomes more expensive for foreigners to afford British goods decreasing net exports
trade policy and protectionism, the harder the protectionism abroad, the harder it is for domestic producers to export their goods

Question 34

What are the determinants of net exports pt2 ?

Answer 34

relative inflation rates in the 2 countries
the exchange rates a rise in the value of the pound means it becomes more expensive for foreigners to afford British goods decreasing net exports
trade policy and protectionism, the harder the protectionism abroad, the harder it is for domestic producers to export their goods

Question 35

What determines aggregate demand summary ?

Answer 35

Question 36

What determines aggregate demand summary ?

Answer 36

Question 37

Why is the AD curve downwards sloping ?

Answer 37

• wealth effect
• Net exports effect
• interest rate effect

Question 38

What is the wealth effect ?

Answer 38

If the average price level falls, existing wealth can buy greater goods and services. This means households can spend more and there in increasing in consumption, leading to a rise in AD. Visa Versa

Question 39

What is the net exports effect

Answer 39

If the average price level rises, this leads to domestically-produced goods and services being less internationally price competitive. Meaning net exports are likely to fall thus AD falls. Visa versa

Question 40

What is the interest rate effect ?

Answer 40

When the average price level rises, economic agents are likely to borrow to finance their consumption. This will lead to a rise in the price of borrowing, which is the interest rate. Increased interest rate then leads to a fall in both consumption and investment which decreases AD

Question 41

What can cause the AD curve to shift ?

Answer 41

Is there any component of AD that has changed due to something OTHER THAN price level.
E.G:
- an increase in consumer confidence (this would increase consumption)
- an increase in business optimism (this would increase investment)
- a fall in the relative value of the domestic currency (this would increase net exports)

Question 42

Chain of reasoning example

Answer 42

an increase in the rate of income tax
An increase in the rate of income tax is likely to lead to a fall in disposable income for households. This will lead to a fall in consumption spending. Since consumption is a component of AD, this will cause AD to decrease. This is shown by a leftward shift of the AD curve.