2.2 Aggregate Demand Flashcards
Define aggregate demand
The total demand for goods and services produced in an economy at a given price level
What are the components of AD?
Consumption Investment Government Spending Exports Imports
What is the calculation of AD?
C + I + G + (X-M)
What percentage of AD is consumption?
65%
What percentage of AD is government spending?
Why is this percentage an understatement?
22.5%
Public spending on investment is treated as I, not G
What percentage of AD is investment?
What is also included as part of investment?
15%
Changes in inventory holdings is included
What did John Maynard Keynes say was the most important determinant of total household spending?
In which book did he say this?
Disposable income
The general theory of employment, interest and money
Define disposable income
The income that households have to devote to consumption and saving after they have paid their direct taxes and received any state welfare benefits
What else did John Maynard Keynes say about the relationship between disposable incomes and consumption?
If consumer incomes rose, they would not spend all of the increase
Define average propensity to consume
The proportion of income that households devote to consumption
Define marginal propensity to consume
The proportion of additional income devoted to consumption
Define marginal propensity to save
The proportion of an increase in disposable income that households would devote to spending
How are Milton Freidman’s views on consumption different to Keynes?
‘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.
What is the other theory of consumption?
The ‘Life-cycle hypothesis’, developed by Ando Modigliani. Stated households smooth their consumption over their lifetimes, on the basis of their expected future incomes.
Apart from incomes, what can affect consumption? (4)
- The wealth effect
- Consumer confidence (the state of the economy)
- Interest rates
- Expectations of future inflation
Are all of the factors that affect consumption instantaneous?
No, time lags are associated with some factors
What is the consumption function?
The relationship between consumption and disposable income; its position depends on the other factors that affect how much households spend on consumption.
Show the consumption function on a diagram
Search up
Define investment
Expenditure by firms to add to the capital stock
How does investment contribute to the economy?
It leads to an increase in the productive capacity of the economy by increasing the stock of capital available for production
Apart from to increase productive capacity, why may firms need to invest?
Due to the depreciation of old capital (capital wearing out)
What are the factors affecting investment? (8)
- 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)
How would the overall state of the economy affect investment?
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
How can international competitiveness impact the rate of investment?
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
How may expected levels of inflation influence the level of investment?
A high rate of inflation creates uncertainty, which may dampen firms expectations regarding future demand
How do firms finance investment? (2)
- Borrowing
- Using past profits
Apart from a firm’s willingness to borrow, what else can affect whether a firm can borrow?
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.
What does net government expenditure vary alongside?
The business cycle
What factors affect the level of trade in goods or services? (5)
- 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
Define aggregate demand curve
The relationship between the level of AD and the overall price level; it shows planned expenditure at any given possible overall price level
How does an AD curve differ from microeconomic demand curves?
A microeconomic demand curve focuses on individual products and prices
Why is an AD curve downward sloping?
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
How can interest rates help to explain why the AD curve is downwards sloping?
When prices are relatively low, interest rates also tend to be quite low, which would likely encourage investment and consumption
How can exports and imports help to explain why the AD curve is downwards sloping?
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
What causes a…
- Movement along the AD curve?
- Shift in the AD curve
- A change in the GPL
- A change in one of the components of AD
How do exchange rates affect the (X-M) component of AD?
S Strong P Pound I Imports C Cheaper E Exports D Dearer
What is the wealth effect?
When a households wealth increases, for example their homes or assets increase in value, they feel richer, so consumption may increase
What is net investment?
Gross investment - Capital depreciation
Explain animal spirits.
Who came up with the idea of animal spirits?
Animal spirits refer to the confidence or pessimism held by consumers and firms.
John Maynard Keynes
What is the accelerator effect and what component of AD does it relate to?
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.
Why do governments spend money? (3)
- To manipulate the economy through fiscal policy
- Ensure a minimum standard of living
- Compensate for market failures
