2.2 Aggregate Demand

Question 1

Define aggregate demand

Answer 1

The total demand for goods and services produced in an economy at a given price level

Question 2

What are the components of AD?

Answer 2

Consumption
Investment
Government Spending
Exports
Imports

Question 3

What is the calculation of AD?

Answer 3

C + I + G + (X-M)

Question 4

What percentage of AD is consumption?

Answer 4

65%

Question 5

What percentage of AD is government spending?

Why is this percentage an understatement?

Answer 5

22.5%

Public spending on investment is treated as I, not G

Question 6

What percentage of AD is investment?

What is also included as part of investment?

Answer 6

15%

Changes in inventory holdings is included

Question 7

What did John Maynard Keynes say was the most important determinant of total household spending?
In which book did he say this?

Answer 7

Disposable income

The general theory of employment, interest and money

Question 8

Define disposable income

Answer 8

The income that households have to devote to consumption and saving after they have paid their direct taxes and received any state welfare benefits

Question 9

What else did John Maynard Keynes say about the relationship between disposable incomes and consumption?

Answer 9

If consumer incomes rose, they would not spend all of the increase

Question 10

Define average propensity to consume

Answer 10

The proportion of income that households devote to consumption

Question 11

Define marginal propensity to consume

Answer 11

The proportion of additional income devoted to consumption

Question 12

Define marginal propensity to save

Answer 12

The proportion of an increase in disposable income that households would devote to spending

Question 13

How are Milton Freidman’s views on consumption different to Keynes?

Answer 13

‘Permanent income hypothesis’, which suggests consumers base their consumption decisions on their permanent, or normal income levels (what they expect to receive over a 5-10 year period). He argues that transitionary changes in income do not necessarily affect consumption patterns.

Question 14

What is the other theory of consumption?

Answer 14

The ‘Life-cycle hypothesis’, developed by Ando Modigliani. Stated households smooth their consumption over their lifetimes, on the basis of their expected future incomes.

Question 15

Apart from incomes, what can affect consumption? (4)

Answer 15

• The wealth effect
• Consumer confidence (the state of the economy)
• Interest rates
• Expectations of future inflation

Question 16

Are all of the factors that affect consumption instantaneous?

Answer 16

No, time lags are associated with some factors

Question 17

What is the consumption function?

Answer 17

The relationship between consumption and disposable income; its position depends on the other factors that affect how much households spend on consumption.

Question 18

Show the consumption function on a diagram

Answer 18

Search up

Question 19

Define investment

Answer 19

Expenditure by firms to add to the capital stock

Question 20

How does investment contribute to the economy?

Answer 20

It leads to an increase in the productive capacity of the economy by increasing the stock of capital available for production

Question 21

Apart from to increase productive capacity, why may firms need to invest?

Answer 21

Due to the depreciation of old capital (capital wearing out)

Question 22

What are the factors affecting investment? (8)

Answer 22

• Business confidence (the overall state of the economy)
• Animal spirits
• Expectations of future demand
• International competitiveness
• Government policies
• Level of expected inflation
• Availability of credit
• Interest rates (cost of borrowing)

Question 23

How would the overall state of the economy affect investment?

Answer 23

If the economy is going through a period of rapid economic growth, firms may feel more optimistic about future demand, so may wish to exploit the opportunities for profit

Question 24

How can international competitiveness impact the rate of investment?

Answer 24

When demand for exports is high, this can offset the effects of low demand in the domestic economy, hence the decision to invest is less dependent on the domestic economy

Question 25

How may expected levels of inflation influence the level of investment?

Answer 25

A high rate of inflation creates uncertainty, which may dampen firms expectations regarding future demand

Question 26

How do firms finance investment? (2)

Answer 26

• Borrowing

- Using past profits

Question 27

Apart from a firm’s willingness to borrow, what else can affect whether a firm can borrow?

Answer 27

Access to credit- if commercial banks are adverse to risk, they may not be willing to lend. Also, if people are not saving in banks, they may not have the funds to lend.

Question 28

What does net government expenditure vary alongside?

Answer 28

The business cycle

Question 29

What factors affect the level of trade in goods or services? (5)

Answer 29

• Exchange rates
• Protectionist policies
• Relative prices in the UK compared to the rest of the world
• Aggregate domestic income will affect imports
• Aggregate incomes abroad will affect exports

Question 30

Define aggregate demand curve

Answer 30

The relationship between the level of AD and the overall price level; it shows planned expenditure at any given possible overall price level

Question 31

How does an AD curve differ from microeconomic demand curves?

Answer 31

A microeconomic demand curve focuses on individual products and prices

Question 32

Why is an AD curve downward sloping?

Answer 32

When the GPL is relatively low, the purchasing power of incomes are relatively high, meaning real incomes can be considered relatively high, meaning a low GPL means high consumption

Question 33

How can interest rates help to explain why the AD curve is downwards sloping?

Answer 33

When prices are relatively low, interest rates also tend to be quite low, which would likely encourage investment and consumption

Question 34

How can exports and imports help to explain why the AD curve is downwards sloping?

Answer 34

When the GPL is relatively low, this will increase the competitiveness of UK goods, leading to an increase in foreign demand for UK exports, and a reduction in domestic demand for imports, as people switch to buying UK goods and services

Question 35

What causes a…

• Movement along the AD curve?
• Shift in the AD curve

Answer 35

• A change in the GPL

- A change in one of the components of AD

Question 36

How do exchange rates affect the (X-M) component of AD?

Answer 36

S Strong
P Pound
I Imports
C Cheaper
E Exports 
D Dearer

Question 37

What is the wealth effect?

Answer 37

When a households wealth increases, for example their homes or assets increase in value, they feel richer, so consumption may increase

Question 38

What is net investment?

Answer 38

Gross investment - Capital depreciation

Question 39

Explain animal spirits.

Who came up with the idea of animal spirits?

Answer 39

Animal spirits refer to the confidence or pessimism held by consumers and firms.
John Maynard Keynes

Question 40

What is the accelerator effect and what component of AD does it relate to?

Answer 40

The relationship between planned capital investment and the rate of change of GDP.
When demand increases, firms will initially run down their existing productive capacity, but to meet future demand, they must invest.

Question 41

Why do governments spend money? (3)

Answer 41

• To manipulate the economy through fiscal policy
• Ensure a minimum standard of living
• Compensate for market failures