2.2 Flashcards
What is aggregate demand ?
The total demand for goods and services within an economy
What does aggregate demand measure ?
It measures spending on goods and services by consumers, firms, the government and overseas consumers and firms.
What is the equation for aggregate demand ?
C + I + G + (X-M)
What is consumer spending ?
- How much consumers spend on goods and services.
- This is the largest component of AD, around 65 %
What is investment ?
- This is business spending on capital goods.
- It accounts for around 15-20% of GDP in the UK per annum
What is government spending ?
- This is how much the government spends on state goods and services, such as schools and the NHS.
- It accounts for 18-20% of GDP
What is X-M ?
- Exports - imports
- This is the value of the current account on the balance of payments.
- A positive value indicates a surplus, whilst a negative value indicates a deficit
- Can also be called net trade
What causes movement along the AD curve ?
A change in the price level
What are the reasons for the downward sloping curve ?
- The wealth effect
- The international trade effect
- The interest rate effect
What does an increase in price level show ?
Inflation
What does a general decrease in price level show ?
Deflation
What does an increase in GDP mean ?
An increase in GDP will lead to positive economic growth, lower unemployment, a current account moving into surplus and an overall boom
What does a decrease in GDP mean ?
A decrease in GDP will lead to negative economic growth, higher unemployment, a current account moving into deficit and an overall recession.
What causes a shift in AD ?
- It is caused by a change in the determinants of aggregate demand
- This is C + I + G + (X-M)
What does a shift to the right mean ?
It means that aggregate demand increases: for any price level, a larger amount of real GDP is demanded
What does a shift to the left mean ?
It means that aggregate demand decreases : for any price level, a smaller amount of real GDP is demanded
What causes a fall in AD ?
- Fall in exports (X
What causes a rise in AD ?
- Rise in exports (X>M)
- Depreciation in the value of the exchange rate
- Cuts in the rate of direct and indirect taxes
- More supply of credit being given out by creditor
- Lower interest rates
What is the wealth effect ?
It refers to when changes in the price level affect the real value of peoples wealth
What happens when the price level increases (wealth effect) ?
- When the PL rises, the real value of wealth falls, people then cut back on their spending
- Movement to the left along the AD curve
What happens when the price level decreases (wealth effect)?
- When the PL decreases, the real value of wealth increases, people increase their spending
- Movement to the right along the AD curve
What is the international trade effect ?
It refers to the change in value of exports and imports
What happens when the price level increases (trade effect) ?
- Rising price level produces a fall in exports and a rise in imports, so net trade falls
- Imports are cheaper whereas exports are dearer
- This represents a fall in quantity of output demanded which causes a movement to the left along the AD curve
- SPICED
What happens when the price level decreases (trade effect) ?
- Falling price level produces a rise in exports and a fall in imports so that net trade rises
- Exports are cheaper whereas imports are dearer
- This represents a rise in quantity of output demanded which causes a movement to the right along the AD curve
- WPIDEC
What happens when the price level decreases (trade effect) ?
- Falling price level produces a rise in exports and a fall in imports so that net trade rises
- Exports are cheaper whereas imports are dearer
- This represents a rise in quantity of output demanded which causes a movement to the right along the AD curve
- WPIDEC
- Movement to the right long the curve
What is the interest rate effect ?
Refers to when changes in the price level affect the rate of interest
What happens when the price level increases (interest rate effect) ?
- If there is an increase in the price level, consumers and firms need more money to carry out their purchases and transactions
- This leads to an increase in the demand for money which leads to an increase in rates of interest
- This increases the cost of borrowing leading to a decrease in consumer purchases which are financed by borrowing
- A movement to the left along the AD curve
What happens when the price level decreases (interest rate effect) ?
- If there is a decrease in the price level, consumers and firms need less money to carry out their purchases and transactions
- This leads to a decrease in the demand for money which leads to a decrease in rates of interest
- This decreases the cost of borrowing leading to an increase in consumer purchases which are financed by borrowing
- A movement to the right along the AD curve
What factors affect consumer spending ?
- Real disposable income
- Direct taxation e.g. income tax or national insurance
- Consumer confidence and expectations
- The rate of interest
- The supply of credit
- Expectations of inflation
What effect does real disposable income have on consumer spending ?
An increase in real disposable income will allow consumers to spend more. This is the most important factor affecting consumer spending.
What effect does direct taxation have on consumer spending ?
- If there is a cut in direct taxation then, other factors remaining the same, consumers will experience an increase in their disposable income and increase spending
- In contrast, a hike in indirect taxes such as import duties or VAT will cause prices to rise and real incomes to decline and decreased spending
What effect does consumer confidence and expectations have on consumer spending ?
Fears of rising unemployment and expectations of higher taxes will hit consumer sentiment and spending, it will decrease spending.
What effect does the rate of interest have on consumer spending ?
- Higher interest rates increase cost of spending on mortgages. Therefore higher rates will lead to lower spending as consumers have lower discretionary income
- Lower interest rates may therefore lead to more consumer spending
What effect does the supply of credit have on consumer spending ?
A lower supply of credit means that consumers cannot borrow to spend, thus consumer spending falls
What effect does expectation of inflation have on consumer spending ?
If there are anticipated price rises you would expect there to be increases in consumer spending, particularly on durables, to avoid future price rises
What is investment ?
- Investment is the addition of capital stock that is used to produce other goods and services
- An example of this would be investment in capital goods
When does investment take place, in the eyes of an economist ?
For an economist investment only takes place if real products are created
What is depreciation ?
Depreciation is the decrease in the value of stock
What causes depreciation ?
Depreciation is caused by the wear of stock over time as it is used
What is gross investment ?
Gross investment measures investment before depreciation
What is net investment ?
Net investment is gross investment adjusted for depreciation
What are the two different types of capital ?
- Human Capital
- Physical Capital
What is investment in human capital ?
Investment in the education and training of workers
What is investment in physical capital ?
Investment in factories and machinery etc
How can investment be financed ?
- Retained profit
- Firms borrowing money from banks
How does the rate of interest affect levels of investment (borrowing) ?
- The higher the rate of interest, the lower the profit from any investment will be, ceteris paribus.
- A rise in interest rates will therefore reduce the number of profitable investment projects and so firms will invest less.
- The lower the rate of interest, the more investment projects will be profitable and so there will more investment.
What is retained profit ?
Savings that firms keep and do not distribute to their owners
How does the rate of interest affect levels of investment (retained profit) ?
- The higher the rate of interest that banks offer on savings, the more attractive it is for firms to save money rather than invest it in physical capital.
- The lower the rate of interest, the greater the incentive for firms to run down their savings and invest
What are the determinants of investment ?
- Changes in interest rates
- Changes in business confidence
- Changes in technology
- Changes in business taxes
- The level of corporate indebtedness
- Legal changes
How does business confidence affect investment ?
- If businesses are optimistic, they spend more on investment, and the AD curve shifts to the right
- If businesses are pessimistic, they spend less on investment, and the AD curve shifts to the left
How do interest rates affect investment ?
- Increases in interest rates raise the cost of borrowing, and force businesses to reduce investment spending financed by borrowing, and therefore the AD curve shifts to the left.
- Decreases in interest rates mean businesses can now finance their investment spending by borrowing at a lower cost, and the AD curve shifts to the right
How does technology affect investment ?
Improvements in technology stimulate investment spending, therefore causing increases in aggregate demand and the AD curve shifting to the right
How do business taxes affect investment ?
- Increasing taxes causes for investment spending to decrease and the AD curve to shift to the left
- Decreasing taxes cause for investment spending to increase and the AD curve to shift to the right
How does the level of corporate indebtedness affect investment ?
- If businesses have high levels of debt, they would be less inclined to make investments and the AD curve shifts to the left
- A low level of debt leads to more investment and a shift to the right on the AD curve
How do legal changes affect investment ?
- For example, small businesses often do not have access to credit, meaning they cannot borrow easily to finance investments.
- Many developing and transition economies do not have the necessary laws that secure property rights
- In such situations, increasing access to credit (the ability to borrow) and securing property rights would result in increases in investment spending, shifting the AD curve to the right.
What is government spending ?
Government spending is expenditure by the government in to public services
Give some examples of public services
- Health
- Education
- Defence
What is capital spending ?
- Investment spending by the government
- e.g. on motorways and defence schemes
What could be the effects of the economy expanding ?
- The government will likely spend less :
- Fewer people may be out of work,less spending on unemployment benefits.
- Working households may see pay increases, less needs to be spent on other forms of benefits.
- Some people will choose to pay for private healthcare or private education, so there may be less spendingneeded on the NHS or schools.
- Crime levels tend to be lower when the economy is growing, so less spending needed on the police.
How would changes in political priorities affect government spending ?
- It may decide to increase or decrease its expenditure in response to changes in its priorities
- Increased government spending means a shift to the right
- Decreased government spending means a shift to the left
How would changes in economic priorities affect government spending ?
- Increase in government spending would shift the curve to the right
- Decrease in government spending would shift the curve to the left
How would changes in national income abroad affect government spending ?
- Consider aggregate demand in country A, which has trade links with country B.
- If country B’s national income increases, it will import more goods and services from country A, so country A’s exports will increase.
- Therefore the AD curve in country A shifts to the right.
- If, on the other hand, country B’s national income falls, it will buy less from country A, and country A’s AD curve shifts to the left.
What is an exchange rate ?
An exchange rate is the price of one country’s currency in terms of another country’s currency
How would changes in exchange rates abroad affect government spending ?
- Consider again country A, and assume that the price of its currency increases
- Country B now finds country A’s output more expensive, and so it imports less from country A; therefore, country A’s exports fall, and its AD curve shifts to the left.
- At the same time, country A now finds country B’s output cheaper, and so it increases its imports from country B.
- A fall in its exports and an increase in imports so that net exports, X - M, fall, and the AD curve shifts to the left.
- In the opposite situation, where the price of country A’s currency decreases, X - M increases, and country A’s AD curve shifts to the right.
How could you remember this when the pound is stronger?
- Stronger Pound
- Imports Cheaper
- Exports Dearer
- Net trade decreases (X
How could you remember this when the pound is weaker?
- Weaker Pound
- Imports Dear
- Exports Cheaper
- Net trade increases (X>M)
- AD increases
What does ‘level of trade protection’ refer to ?
It refers to restrictions to international trade imposed by governments
How would changes in the level of trade protection affect government spending ?
- Suppose country A trades freely with country B (with no trade restrictions). However, country B’s government decides to impose restrictions on imports from country A.
- Country A’s exports will fall, and its AD curve will shift to the left.
- On the other hand, in country B, lower imports mean that the value of X - M increases, and its AD curve shifts to the right.
When GDP is rising why will there be more tax revenue ?
- More revenue from income tax, as people’s income rises, and more people are in work.
- Extra revenue from corporation tax, as business profits rise.
- Higher revenue from VAT / sales taxes, as people spend more on goods and services.
