2.2 Aggregate Demand Flashcards
Aggregate Demand
Total level of spending in the economy at any given price over a given time period
AD Formula
C + I + G + (X - M)
Components of AD
Consumption - consumer spending on goods and services
Investments - spending on capital goods
Government Spending - spending on public and merit goods by government
Net Trade - exports minus imports
AD Curve
Same as demand curve but shows relationship between price level and real GDP
Downward Sloping:
- Income Effect
- Substitution Effect
- Real Balance Effect
- Interest Rate Effect
AD Curve
Income Effect
As a rise in prices is not matched by rise in income, people have lower real incomes so can afford to buy less leading to a contraction in demand
AD Curve
Substitution Effect
If prices in UK rise, less foreigners will want to buy British exports and more UK residents will want to buy imported foreign goods as they are cheaper
Rise in imports and fall of exports decreases net trade so AD will contract
AD Curve
Real Balance Effect
Rise in prices will mean amount people have saved will no longer be worth as much so will offer less security
As a result, they will want to save more and reduce spending
Contraction in AD
AD Curve
Interest Rate Effect
Rising prices means firm have to pay workers more thus there is higher demands for money
If supply stays the same, price of money (interest rates) will rise
Higher interest rates mean more people save and less borrow and will mean businesses invest less
Contraction in AD
Movements and Shifts
Movement is caused by change in prices
Shift is caused by any other variable
A fall in consumption reduces AD but fall in rate of rise of consumption means consumption is still rising so AD will increase but by not as much
Disposable Income (Y)
Money consumers have left to spend after taxes
Most important factor in determining consumption levels
Marginal propensity to consume (MPC)
Average propensity to consume (APC)
Marginal Propensity to Consume
How much an increase in income affects consumptions
0 - 1 = income increase increases spending but spending doesn’t increase as much
1+ = use borrowing or savings to fulfil demand for goods which is higher than their income increase
Poor likely to have higher MPC than rich
= Change in Consumption / Change in Income
Average Propensity to Consume
Average amount spent on consumption out of total income
APC for economy is likely to be less than 1 in an industrialised country
= Total Consumption / Total Income
Relationship between savings and consumption
Saving is what is not spent from income
Increase in consumption decreases savings => factors affecting consumption are same for savings but in the opposite way
Marginal propensity to save (MPS) is how much an increase in income is saved whilst average propensity to save (APS) is average amount saved from income
MPS and APS formulas
MPS = Change in Savings / Change in Income
APS = Total Savings / Total Income
Influences on Consumer Spending
Disposable Income Interest Rates Consumer Confidence Wealth Effects Distribution of Income Tastes and Attitudes
Influences on Consumer Spending
Interest Rates
Most major expenditures are bought on credit so interest rate affects cost of good for consumers
If rates are high, price of good will effectively be higher since more interests needs to be paid back => fall in consumption
High rates also increase mortgage repayments => fall in consumption
Rise in rates decreases value of shares => negative wealth effect
Influences on Consumer Spending
Consumer Confidence
If people are confident about future and expect pay rises, they will continue or increase spending
If they expect high inflation, they will buy now at cheaper price => increased consumption
Recession or unemployment => reduced consumption
Tax also has same effect
Influences on Consumer Spending
Wealth Effects
Wealth is a stock of assets
People with greater wealth have greater levels of consumption
Wealth effect is experienced when real house prices rise as owners now have more wealth so are more confident with spending
Also experienced when share prices rise
Greater wealth increases consumer confidence => increased spending
Influences on Consumer Spending
Distribution of Income
Those on high incomes tend to save higher percentage of incomes than those on low so a change in distribution of money in economy will affect level of consumption
If money is moved from rich to poor, consumption is likely to increase as poor have higher MPC
Influences on Consumer Spending
Tastes and Attitudes
There is a strong materialistic drive encouraging people to have the newest and best => spending is high, sometimes even above income
If people were less materialistic, consumption would decrease
Investment
Additional of capital stock to an economy
Only seen as investment if real products are created so buying a share in a company would be saving but new machinery is investments
Gross and Net Investment
Gross investment is amount of investment carried out and ignores level of depreciation
Net investment is gross investment minus value of depreciation
Influences on Investment
Rate of Economic Growth Business Expectations and Confidence Demand for Exports Interest Rates Influence of Government and Regulations Access to Credit Retained Profit Technological Change Costs
Influences on Investment
Rate of Economic Growth
Higher levels of investment in a growing economy as business would be more confident about their investments and higher demand leads to higher return rate on investments
Growing economies need more investments in order to cope with higher levels of demand
Vice versa for an economy in decline
If same products and same output is being produced every year and demand is constant, investment will stay same as firms only need to replace old machines
Accelerator Theory
Accelerator Theory
Investment over a period of time is the change in real income * the capital output ratio
Capital output ration is the amount of investment needed to produce a given amount of goods
Thus, if incomes rise, the level of investment will rise
Influences on Investment
Business Expectations and Confidence
When businesses are confident about the future and expect growth, investments increase as they want to prepare
If they are fearful of the future, they will not invest money in new ideas or machinery
Influences on Investment
Demand for Exports
If the world economy is booming, demand for exports is likely to increase and therefore exporting firms’ investment is likely to increase to cope with extra demand
Knock on effect encouraging firms to increase investments
Influences on Investment
Interest Rates
Most investment is done through borrowing
High interest rates mean borrowing is more expensive so a business needs to be more confident of good profits to cover costs
Rise in interest rates leads to investing though retained profits or savings => opportunity cost
Influences on Investment
Influence of Government and Regulations
Governments can encourage investment by policy decisions (tax breaks or grants or subsidies)
Regulations also affect investment as a highly regulated economy tends to see less investment as regulation increases cost and time taken to invest
Influences on Investment
Access to Credit
Investment will be lower when an investment has a high risk attached as there will be less access to credit and interest rates will be higher
In recessions, it is more difficult to access credit as risks are higher and banks become more risk aware fearing firms will be unable to pay back
Influences on Investment
Retained Profit
Profits kept by a firm and not shared with shareholders or used to pay taxes
More retained profit => more investments
Influences on Investment
Technological Change
Improvements in technology speed up production which increases level of profitability => investments have a better prospect of success
Change also means businesses need to invest to keep up with the best technology
Influences on Investment
Costs
Rise in costs of any capital project increases level of risk taken => reduced investments
Rises in costs of making goods decreases investments as it reduces profitability => firms have less to invest and decreases rate of return
Net Trade
Exporting goods abroad brings money into the country as there is an increase in AD
Importing goods from abroad takes away money from the country
Total exports - total imports
Influences on Net Trade Balance
Real Income Exchange Rates State of World Economy Degree of Protectionism Non-Price Factors Prices
Influences on Net Trade Balance
Real Income
When real income is high, imports increase as people demand more goods and services and the country is unable to meet needs
=> Net trade decreases
If increase in real income is due to export-led growth, net trade increases
Influences on Net Trade Balance
Exchange Rates
Strong pound means imports cheap and exports dear as it costs foreigners more to buy pounds with their currency
=> Imports increase and exports decrease so net trade decreases
Depends on elasticity of imports and exports
If imports price elastic, rise in price causes a large fall in demand so value of imports fall
If price rise and PED is inelastic, rise in value, vice versa
Both imports and exports elastic, rise in value of pound leads to fall in net trade
Influences on Net Trade Balance
State of World Economy
If UK’s main export country is doing well, UK exports likely to increase => net trade increase
Effect of state of world economy is dependent on which countries are doing well and trade relationship UK has
Influences on Net Trade Balance
Degree of Protectionism
Attempt to prevent domestic producers suffering from competition abroad
Tariffs, quotas and technically barriers introduced making it harder for foreign producers to sell goods in UK
High protectionism on UK exports => exports decrease
High protectionism on UK imports => imports decrease
Influences on Net Trade Balance
Non-Price Factors
Quality and design and marketing
If UK goods are of higher quality and design, exports high as foreign demand increases and imports decrease and people buy British instead of foreign
=> Net trade increases
If UK goods well marketed, stronger desire to buy => exports increase and imports decrease
Strong quality/design and market => British exports more inelastic
Influences on Net Trade Balance
Prices
High prices of UK goods mean goods are less competitive compared to international goods since people make decisions according to price
=> Volume of exports decrease and volume of imports increase
Prices affect by inflation rate - if UK inflation higher, prices rise faster
Also affected by productivity => high leads to lower costs so prices low
If PED is elastic, high prices => fall in net trade
