1.2 Aggregate Demand

Question 1

What is aggregate demand?

Answer 1

Aggregate Demand - the total spending on domestically produced goods and services in an economy over a given period of time

Question 2

What is Aggregate Demand made up of?

Answer 2

1. Consumption (C): - total spending by households on goods and services in an economy over a given period of time
2. Investment (I) - total spending by firms on capital goods in an economy in a given period of time
3. Government Expenditure (G) - total spending by the governments on goods and services in a given period of time
4. Net Exports (X - M) - total export revenue - total import expenditure

Question 3

What is the main factor affecting Consumption?

Answer 3

• most important factor contributing to C is disposable income (income after tax)

Question 4

What is the average propensity to consume?

Answer 4

Average Propensity to Consume - The ratio of consumption (C) to disposable income (Y) ( C / Y)

Question 5

What is the average propensity to save?

Answer 5

Average Propensity to Save - the ratio of saving to disposable income (S/Y)

Question 6

What is the marginal propensity to consume?

Answer 6

Marginal Propensity to Consume - Measures change in consumption ( ^C ) from changes in disposable income (^Y) (^C / ^Y)

Question 7

What are the 4 steps of the multiplier effect?

Answer 7

1. An injection into the CFOI leads to more income for households (e.g gvnmt spending)
2. Households spend part of this and save part of this additional income depending on MPC and MPS
3. Firms respond to this additional demand by increasing output of goods and services and will increase factor payments (wage, profit) to factors of production which are owned by the households
4. This will increase income to households which will start the process once again and will loop till the spending becomes smaller and smaller, eventually reaching 0
   - the final change in national income is greater than the injection MULTIPLIER EFFECT

Question 8

What is the formula for calculating the Multiplier

Answer 8

Multiplier = Final Change in Initial Income / Initial Change in National Income = 1/1 - MPC

Question 9

What are withdrawals and what do they consist of?n

Answer 9

• There can also be withdrawals on consumers additional income in the multiplier effect
• These consist of Savings, Taxation and Spending on Imports
• We can use this to calculate the MPW (The marginal propensity to withdraw), it consists of:
  
  • MPS = Marginal Propensity to Save= ^S/^Y
  • MPM = Marginal Propensity to Import = ^M/ ^Y
  • MPT = Marginal Propensity to Tax= ^T/^Y
  • MPW = MPS + MPM + MPT

Question 10

What do the MPC and the MPW add to?

Answer 10

1

Question 11

What is the MPW formula for multiplier

Answer 11

1/MPW

Question 12

What are the 5 other determinants of consumption

Answer 12

1. Wealth (The value of the stock of assets a household has at a given point in time)
   
   • An increase in the value of assets a household has will lead to an increase in wealth which will increase consumption
2. Age
   
   • The young and the old tend to spend higher proportions of income (the young take on debt for families or housing and the old may start to run out of savings)
3. Interest Rate
   
   • Consumers undertake borrowing in order to purchase durable household goods and housing, so higher interest rates mean that mortgage and loan repayments increase so consumers have less disposable income for consumption (the reward for saving also increases)
   • Therefore increasing interest rates lead to lower consumption
4. Consumer Confidence
   
   • If consumers think their situation will stay the same or improve they will spend more or the same on durable goods and non essential goods (holidays) and vice versa
   • CC is high during economic boom and low during recession, higher CC means more consumption
5. Inflationary Expectations
   
   • If consumers expect the price level to rise in the future they will bring forward purchases, so expectations of future price changes can lead to increased consumption and less saving
   • However higher price levels erode PPP (and therefore wealth) so consumers may be encouraged to save more

Question 13

What is investment?

Answer 13

Investment - the addition to the physical capital stock of the economy which can then be used to produce other goods and services

Question 14

What is net investment

Answer 14

Gross Investment - Depreciation

Question 15

What is Gross Fixed Capital Formation

Answer 15

• word for investment on data sheets

Question 16

What are the 8 determinants of investment?

Answer 16

1. Interest Rates
   
   • **Firms finance investment by borrowing or through retained profits, so if the cost of borrowing increases then firms will find it more expensive and certain investment projects will not be viable/profitable
   • If the interest rate is high, firms will also prefer to save retained profits instead of investing
   • Therefore investment is negatively related to the rate of interest
2. Real Disposable Income
   
   • If the economy is expanding and consumers spend more on goods and services then firms will have to spend more on physical capital to produce more goods and services
   • Therefore increases in real disposable income lead to increases in investment
3. Business Expectations and Confidence
   
   • If firms expect sales to increase they will invest more in physical capital \
   • If firms have low confidence in the economy, investment will fall
4. Retained Profits
   
   • Retained Profits are profits kept back by the firm and not distributed to shareholders
   • If retained profits are high, then investment will also be high and firms will not have to finance investment via borrowing
5. Access to Credit
   
   • If banks are willing to lend and/or there is a well developed financial sector, investment will increase due to ease of borrowing
6. Corporation Tax
   
   • If corporation tax increases, firms are left with less profit so they have less to invest
   • Therefore corporation tax has a negative impact on investment
7. The World Economy
   
   • If there is a recession in one of our trading partners countries then there will be a decline in the exports to those countries
   • This means that export firms will invest less as they are exporting less
   • This will mean lower revenue for other firms and further unwillingness to invest
8. Government
   
   • The government can provide environments in which it is easier to invest (deregulation, lower corporation tax)

Question 17

What is the accelerator effect?

Answer 17

Accelerator Effect - When an increase in the rate of growth of real GDP can lead to a larger than proportional increase in investment (which will further accelerate increases in national income)

Question 18

What is the formula for the accelerator

Answer 18

I = a ∆Y (Investment = Accelerator x Change in National Income)

Question 19

What is induced and replacement investment?

Answer 19

• Induced Investment - purchasing new capital to produce goods and services
• Replacement Investment - purchasing new capital to replace worn out capital

Question 20

Why does investment tend to fluctuate a lot?

Answer 20

• investment tends to fluctuate a lot as it depends on the growth rate of real GDP
• Investment tends to be more volatile than real GDP

Question 21

What is the general breakdown of the accelerator (what happens in cases of falling GDP, slow risng GDP etc.)

Answer 21

• When economy is growing firms will increase both investment in both induced and replacement capital in order to produce additional goods and services for increase in demand
• If real GDP is increasing, but the rate of growth is slowing down then firms will reduce induced investment while still undertaking replacement investment
• If real GDP is constant with no growth then investment will only be replacement investment
• If real GDP is falling or has a negative rate of growth - investment may stop altogether (if no replacement investment is required)

Question 22

Why does the accelerator provide an explanation for the boom-bust cycle

Answer 22

• Investment tends to rise more than proportionally to real GDP growth and will also fall more than proportionally
• This provides explanations why recoveries lead to booms and slowdowns lead to recessions
• Interaction between the multiplier effect and the accelerator effect can increase instability in economic activity

Question 23

What does the size of the accelerator coefficient (a) depend on?

Answer 23

• The size of the accelerator coefficient depends on the ratio of new capital required to produce a certain amount of additional output
• This ratio is generally larger than one since capital goods are durable and last many years
• e.g £4million of induced investment is needed to produce an additional 2 million of annual output, then the marginal capital-output ratio is 2

Question 24

How does the accelerator and the marginal capital output ratio relate?

Answer 24

• Investment = Change in Capital (I = ∆K)
  
  • when an economy invests this leads to an increase in capital stock, and ∆K shows the net increase in capital stock as a result of this
• Investment = a∆Y = ∆K: This means a = ∆K/∆Y = k
• k = marginal capital output ratio

Question 25

what do higher and lower k values mean (marginal capital output)

Answer 25

• higher k values mean more additional capital needed for one unit of output (lower capital efficiency)
• lower k implies higher capital efficiency
• the higher the k values mean, the greater the value of a (accelerator) and the larger the acceleration effect
• however k = a is only applicable in certain condition

Question 26

what is k?

Answer 26

• k = marginal capital output ratio
  
  • measures the additional capital required to produce one more unit of additional output

Question 27

How can you evaluate the accelerator effect and why is it hard to predict? (5)

Answer 27

• Firms may have spare capacity and existing stocks and may be able to meet additional demand without further investment
• The willingness of firms to invest also depends on confidence in future demand (over a long period of time)
• Firms may have long term investment plans which they are not able to change quickly (They may also be affected by other factors such as the cost of finance)
• Firms producing capital goods may not be able to respond quickly to changes in demand from investment
• Firms may try and delay replacing machines that are not completely worn out especially if future outlook is uncertain

Question 28

What is the difference between government expenditure and spending?

Answer 28

Government Spending does not include any transfer payments because no goods or services are being produced in return (not part of GDP)

• transfer payments include things like welfare payments, pensions, benefits
• they are not part of GDP either as it is redistribution of income

Government Expenditure includes all government spending and transfer payments

Question 29

What are 4 factors affecting government spending?

Answer 29

• Political Considerations (election promises) and policy objectives
• Previous commitments to spending
• Overall economic activity and tax revenue amount generated
• Amount government is prepared to borrow/ Rate of Interest

Question 30

What is the definition of exports?

Answer 30

Exports - total spending on domestically produced goods and services by foreign households, firms and governments

Question 31

What is the definition of imports?

Answer 31

Imports - total spending on foreign produced goods and services by domestic households, firms and governments

Question 32

What is the defintion of net exports

Answer 32

Net Exports (X-M) - total value of exports - total value of imports over a given period of time

Question 33

What are the 5 determinants of net exports?

Answer 33

1. Relative Inflation rate in both countries / Price level in the domestic economy (higher price levels mean less competitive exports abroad)
2. Exchange rate (increase pound value means more expensive exports so less of them)
3. Trade Policy and Protectionism (greater the protectionism abroad, the harder it is for domestic producers to export)
4. Real Disposable Income in the domestic economy (higher means more import demand)
5. Real Disposable Income in the foreign economy (higher means more export demand)

Question 34

What is the AD Curve?

Answer 34

The AD curve shows the inverse relationship aggregate demand (total spending on domestically produced goods and services) and the average price level (Real GDP on the X axis)

Question 35

How does the wealth effect mean the AD curve slopes downwards?

Answer 35

• If the average price level falls (measured by CPI), existing wealth that households own can buy a greater amount of goods and services, which means that households feel wealthier and spend more on goods and services thus consumption rises, leading to a rise in AD
• If average price level increases, existing wealth has less purchasing power which means lower AD

Question 36

How does the net exports effect lead to the AD curve sloping downwards?

Answer 36

• If the average price level falls, domestically produced goods and services are more internationally competitive so the demand for our relatively cheaper exports increases while demand for the relatively more expensive imports decreases which will lead to a net exports increase which will lead to a rise in AD
• If the average price level rises, domestically produced goods and services are less internationally competitive so net exports will decrease leading to lower AD

Question 37

How does the interest rate effect lead to the AD curve sloping downwards?

Answer 37

• When the average price level rises (with ceterus paribus) economic agents are more likely to borrow to finance spending, which will lead to a rise in the price of borrowing (interest rate) which means a fall in both consumption and investment which brings AD down
• When the average price level falls (with ceterus paribus) economic agents are less likely to need borrowing to finance spending which means the interest rate will fall leading to greater investment and consumption as the cost of borrowing has fallen leading to a rise in AD

Question 38

What are the factors that cause the AD curve to shift?

Answer 38

• Factors that cause the AD curve to shift are things that change a component of AD (C, I, G , X-M) that are not price level
  
  • e.g increases in consumer confidence (will increase consumption)
  • e.g increases in business optimism (will increase investment)
  • e.g fall in relative value of the domestic currency (decrease in exchange rate) means increase in net exports (relatively cheaper exports and more expensive imports)

Question 39

How does the multiplier effect affect AD shifts?

Answer 39

• What the multiplier effect tells us that the initial shift of the AD curve will be followed by several sequentially smaller shifts of the AD curve and the final change in income (GDP) is greater than the initial change
• This is because an injection/withdrawal in the multiplier effect are from or are shifts of the AD curve
• If the multiplier is 2.5 e.g, a change in real GDP of 100m (injection) will lead to a change in real GDP of 250m

Question 40

What do increases and decreases in AD mean?

Answer 40

• Increases in AD are shown by a shift to the right of the AD curve (greater total spending on goods and services produced in the domestic economy)
• Decreases in AD are shown by a shift to the left of the AD curve (less total spending on goods and services produced in the domestic economy