1.3 - Aggregate demand Flashcards
What is aggregate demand?
Total level of spending on goods and services produced within a country in a given time period. The components are:
Consumption
Investment
Government Expenditure
Exports - Imports
AD = C + I + G + (X-M)
Why does the AD curve slope downwards?
AD curve shows General price level against Real GDP
Real income effect: as price falls, real incomes rise, consumers buy more
Balance of trade effect: fall in relative price of country X makes foreign produced goods/services more expensive, causing rise in exports and fall in imports
Interest rate effect: if inflation is low there is a reduction in interest so less incentive to save. May also cause the exchange rate to depreciate and improve export sales.
How is the multiplier illustrated by the AD curve
AD curve keeps moving outwards
What causes a change in AD?
Consumption: PASIFIC - population, income, interest, fashion, demographics, confidence
Investment: Interest, business confidence, business cycle
G: autonomous spending (have to spend), business cycle, shocks, banking crisis, pandemic - cut in government spending
X-M: Exchange rates, fashion, global trade relations, fall in exports
General: Higher interest rates causes fall - likewise fall in credit from banking systems
Increased house prices and share prices leads to wealth effect - increased confidence.
Likewise expansion of credit, lower interest has same effect
Depreciation in value of exchange rate can cause increased X-M value
What are shocks?
- Rise of fall in exchange rate value
- Recession in nation or trading partners
- Slump in housing market
- Financial Crisis
- Commodity price volatility, usually oil.
What is consumption and the consumption function?
-Total spending on consumer and household goods and services. Income comes from the rewards from the factors of production
labour = wages land = rent capital = interest entrepreneurship = profits
Consumption function - relationship between consumption and what affects it - mainly disposable incomes - positive relationship
What affects the marginal propensity to consume?
- Wealth effect - more likely to consume f assets rising in value or wealth rising in value - similar if stocks, housing etc. rise in value
- Inflation - if rise in price expected consumers buy at a lower price or vice versa
- Interest - rising interest makes loans more expensive and stock values fall, consumption falls. A fall in interest rates does the opposite
- Credit - availability fuels consumption
- Expectations - consumers react to future prices, pay, employment, tax changes and economy
- Demography: young/old have low incomes, high mpc but middle age save so low mpc
What factors influence consumer spending?
- Real disposable incomes - adjusted for inflation and tax
- Employment and job security - confidence and incomes rise confidence - ‘animal spirits’ from Keynes as people spend more as they are more confident in retaining jobs and paying off debt
- Household wealth - value of assets - wealth effect - confidence
- Expectations - uncertainty causes fall, improvement causes raised demand
- Interest - Higher interest makes more expensive to borrow, more saving so spending falls. Lower interest does the opposite.
Why may saving occur - what is savings ratio?
- People postpone consumption - disposable income not spent.
- Savings ratio is the amount of money households have available to save as a percentage of total disposable incomes, also known as average propensity to save
Influenced by:
- Interest
- Price expectations
- Credit
- Job security
- Consumer confidence
- Taxation of savings
- Trust in savings institutions
Why is saving important?
-Businesses save to use as a cushion in recession and can be used to finance takeovers
- Commercial banks use savings deposits to fund investments
- Savings flow into pension funds and then reinvested in stock markets
- Reduce debts for people and firms
- Retirement income
- Can allow households to buy big items
- Allows houses to build up deposits
What is investment?
Addition of capital stock and infrastructure to the economy. Capital goods are goods such as factories, machinery and equipment used to produce for the future.
What is depreciation, gross/net investment and financial capital?
Depreciation - capital wearing out over time and becomes less effective
Gross investment - total amount of money invested over a time period
Net investment is gross investment minus depreciation - could be higher if capital more than depreciation
Financial capital is funds available to finance capital.
3 kinds of capital
Human
Working - used up e.g. steel in car making
Fixed capital - not used up in produciton e.g. robots and machinery
What factors affect investment?
- Actual and expected demand
- Cost of capital
- Availability of credit
- Corporation taxes
- Business confidence/animal spirits - tend to save more when confidence is low as profits are lower than expected and so cut on investment
- Pace of technology in industry
- Subsidies and government intervention
What is the importance of business rates in investment
Investor: either save money getting certain levels of interest or make competing choices with potential rates of return
For firms: firms need to invest but have no profit must borrow, which is part of costs and so lower interest rates mean lower costs
