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
What is the MEC?
-Relationship between planned investment and interest rates demonstrated on a diagram - it is a negative concave slope, shifting right if there are changes which may increase rates of return or left if it is reduced
What impacts MEC/Investment?
- Changes in national income - more money more confidence more investment and projects
- Change in price of capital
- Technological changes may make it more efficient
- Confidence - likely and expected rates of return, often guesses and bring into animal spirits driving the market
- Risk - factors may be unpredictably such as demand, laws, recession, interest and exchange rates
What are the advantages of investment? What is some evaluation
- Injection into circular flow
- More AD
- New capital aids productivity
- Creates extra demand in investment goods industries and lead to strong multiplier effects on level of GDP
- Supports competitiveness and the trade balance in goods and services
Evaluation
New capital may be imported - leakage
Might be time lag between capital and productivity
Some replaces labour, short term unemployment
other factors such as exchange rates
What is the accelerator effect
The level of investment directly correlates to the rate of GDP growth. An increase in GDP therefore leads to an increase in investment and a fall in GDP leads to a fall in investment.
This is because firms will invest when there is increased demand causing an even bigger rise in demand for capital goods
This may be negative if growth slows net investment spending may fall
What does government spending depend on
- Political differences
- Sources of income
- Tradition and history
Where does the money come from
- Revenues from income tax
- Revenues from corporation tax
- VAT
- Capital gain taxes
- Transfer payments - e.g. grants and subsidies
- Charges for services
- Selling assets
- Borrowing through bonds
Why may the government spend less during economic growth?
- Less out of work so less on benefits
- Working households see pay increases so less spent on services
- Some choose to pay for private healthcare and education
- Crime levels lower
Why may a budget deficit be/not be and issue
Issue:
- Debt interest opportunity cost
- Cost borne by future generations
- High risk countries offer high interest to attract lenders
- Annual borrowing adds to debt
Not problem:
-Government can borrow cheaply so provide services at low costs or investment may lead to growth in the future
When may a deficit rise or fail?
Borrowing rises:
- Downturn - benefits, less in work, less tax
- Ageing population
- Banking crisis/pandemic
Borrowing falls:
- Booms and upturns
- Fewer people claim benefits
- Cut benefits for austerity
- Borrowing falls when tax rates rise.
What countries have a surplus/deficit
Surplus: Germany, SK, China, Italy - exports more than imports, circular flow grows, domestic incomes rise
Deficit: UK, US, India - more imports than exports - circular flow less, domestic incomes out
What factors affect demand for exports?
- Real incomes - demand for imports rise
- Relative price of exports
- Exchange rate SPICED
- Non price demand factors
- Strength of AD in export markets - emerging economies
- Protectionism e.g. tariffs, quotas and other trade restrictions.
Why does the UK have a deficit?
- High MPM so when incomes rise importing rises
- Low investment lead to low growth
- Productivity gap - high labour costs and labour laws
- Research gap - little patents and innovation
- Low cost competition of emerging economies
- Cannot compete on quality or price, poor reputation
- Strong GDP draws in imports
- High value of pound SPICED
- Import penetration due to consumer spending and rise of BRICS
- Depletion of North Sea Oil
Why may the effect of a change in exchange rates not be instant?
- Contracts pre signed
- Consumers take time to react to higher prices - loyalties
- Demand and supply inelastic
- Domestic industry takes time to produce the right goods to fill the gaps
What is the impact of a weak pound?
- More competitive abroad, more exports
- Reduced deficit, increased AD and GDP
- Firms switch to exporting
- Encourages domestic growth
- Discourages FDI as make less
- leads to import inflation
- Increase production costs
What are the impacts of a strong pound?
- Low inflation SPICED
- Increased imports
- Low production costs
- Reduced exports
- Encouraged domestic market
- Reduced profitability of UK firms abroad
- Widens deficit - less AD and GDP
- Attracts hot money of foreign investors
What is hot money?
- Stock of quick liquid funds invested in search of the best returns - one of the first effects of exchange rates when interest rates change.
- High interest attracts deposits and demand for the currency so it gets stronger
- During a recession interest falls so exchange rates fall as money leaves the UK
What causes exchange rates to fall?
- Fall in domestic interest
- Higher relative inflation to trade partners - higher cost - exports expensive - demand falls so pound falls
- Relative incomes rise so import more
- Attractive investment abroad
- Speculation it may fall leads it to fall
Why may a trade deficit be/not be a problem?
not a problem:
- UK attracts enough FDI
- Balance insignificant - only important if over 5% of GDP
Problem:
- Failure from government
- Can only spend what is earned, debt rises as need to borrow
- Markets volatile, may not be able to afford in future
- Highlights failures and decline in industry
What are the proportions of the components of AD
Consumption - 60 - 65%
Investment - 12-15%
G - 18-20%
Net imports - -1-4%
How does inflation affect the components of AD?
C - lower disposable incomes unless fixed
I - more expensive interest high loans high
G - higher as more spent on benefits and such
X-M - raise export prices so demand falls for exports
