2.2 Aggregate Demand

Question 1

what are the components of AD?

Answer 1

consumption, investment, government spending, net trade

Question 2

what percentage of AD is made up by consumption?

Answer 2

it makes up about 60% of AD, it is the biggest amount

Question 3

what percentage of AD is made up by investment?

Answer 3

it makes up about 15-20% of AD

Question 4

what percentage of investment is from the private sector?

Answer 4

about 75% of total investment is done by the private sector

Question 5

what percentage of AD is made up from net trade?

Answer 5

it makes up about 5% of AD

Question 6

what percentage of AD is made up from government spending?

Answer 6

about 15-20% of AD is made up of government spending

Question 7

what are the 4 reasons for the AD curve to be downward sloping?

Answer 7

the income effect, the substitution effect, the real balance effect, the interest rate effect

Question 8

what is the income effect?

Answer 8

As a rise in prices is not matched straight away by a rise in income, people have lower real incomes so can afford to buy less, leading to a contraction demand.

Question 9

what is the substitution effect?

Answer 9

If prices in the UK rise, less foreigners will want to buy British exports and more UK residents will want to buy imported foreign goods because they are cheaper. The rise in imports and fall of exports will decrease net exports so AD will contract.

Question 10

what is the real balance effect?

Answer 10

A rise in prices will mean that the amount people have saved up will no longer be worth as much and so will offer less security. As a result, they will want to save more and so reduce their spending, causing a contraction in AD.

Question 11

what is the interest rate effect?

Answer 11

Rising prices mean firms have to pay their workers more and so there is higher demand for money. If supply stays the same, then the ‘price of money’
i.e. interest rates will rise because of this higher demand. Higher interest rates mean that more people will save and less will borrow and will also mean that businesses invest less, so AD will contract.

Question 12

what is a movement along the AD curve caused by?

Answer 12

a change in prices due to inflation or deflation

Question 13

what is a shift of the AD curve shown by?

Answer 13

the shift of the AD curve is shown by an change in the components of AD

Question 14

what is the difference between absolute change and a change in the rate of change?

Answer 14

a fall in the amount of consumption will reduce AD but a fall in the rate of rise of consumption means that consumption is still rising so AD will still increase but by not as much

Question 15

what is consumption?

Answer 15

Consumption is spending on consumer goods and services over a period of time

Question 16

what is disposable income?

Answer 16

Disposable income (Y) is the money consumers have left to spend , after taxes have been taken away and any state benefits have been added.

Question 17

what is most determining factor of the level of consumption?

Answer 17

the amount of disposable income

Question 18

what is the average propensity to consume?

Answer 18

The average propensity to consume (APC) is the average amount spent on consumption out of total income.

Question 19

who have a higher MPC and why, poor or rich?

Answer 19

Poorer people tend to have a higher MPC as they are likely to spend much more of their increase in income whilst richer people are more likely to save it.

Question 20

what is the relationship between consumption and saving?

Answer 20

Savings is what is not spent out of income so An increase in consumption decreases saving

Question 21

what influences consumer spending?

Answer 21

Interest rates, Consumer confidence, Wealth effects, Distribution of income, Tastes and attitudes

Question 22

how does interest rates influence consumer spending?

Answer 22

Most major expenditures are bought on credit therefore the interest rate will affect the cost of the good for consumers. If interest rates are high, the price of the good will effectively be higher since more interest needs to be paid back and this will lead to a reduction in consumption. High interest rates also increase mortgage repayments so reduce consumption. Also, a rise in interest rates decreases the value of shares and so people experience a negative wealth effect.

Question 23

how does consumer confidence influence consumer spending?

Answer 23

If people are confident about the future and expect pay rises, then they will continue or increase their spending. If they expect high levels of inflation in the future, they will buy now as it will be at a cheaper price, so consumption will increase. If they expect a recession and fear possible unemployment, consumption will decrease as people may save more

Question 24

how does the wealth effect influence consumer spending?

Answer 24

Wealth is a stock of assets. People with greater wealth tend to have greater levels of consumption, known as the wealth effect: a change in consumption following a change in wealth. The wealth effect is experienced when real house prices rise as owners have more wealth so are more confident with spending as they know that if they go into financial difficulty they could simply borrow more against the house, since their house is worth more than their current mortgage. it is also experienced with changes in value of other assets such as stocks. Greater wealth will improve a consumer’s confidence and thus lead to greater
spending.

Question 25

how does the distribution of income influence consumer spending?

Answer 25

Those on high incomes tend to save a higher percentage of their income than those on low incomes and so a change in the distribution of money in the economy will affect the level of consumption. If money is moved from the rich to the poor, consumption is likely to increase as the poor have a higher MPC

Question 26

how does the tastes and attitudes influence consumer spending?

Answer 26

In our modern society, there is a strong materialistic drive that encourages people to have the newest and the best and therefore spending can be very high, in some cases even above income. If people were less materialistic, consumption would decrease.

Question 27

define investment?

Answer 27

Investment is the addition of capital stock to the economy i.e. machines and factories used to produce other goods and services.

Question 28

define gross investment?

Answer 28

Gross investment is the amount of investment carried out and ignores the level of depreciation

Question 29

define net investment?

Answer 29

net investment is gross investment minus the value of depreciation.

Question 30

how much does depreciation account for the total level of uk investment?

Answer 30

in the UK depreciation accounts for about 75% of gross investment.

Question 31

how does the rate of economic growth influence the level of investment?

Answer 31

In a growing economy, there will be higher levels of
investment as businesses would be more confident about their investments and the higher demand would lead to a higher return rate on the investment. On top of this, a growing economy needs more investment in
order to cope with the higher levels of demand.

Question 32

define the accelerator theory ?

Answer 32

the investment over a period of time is the change in real income x the capital-output ratio. the capital-output ratio is the amount of investment necessary to produce a given amount of goods. thus if incomes rise, the level of investment rises.

Question 33

how does the business expectations and confidence- (animal spirits) influence the level of investment?

Answer 33

When businesses are confident about the future and expect future growth, investment will increase as
they want to prepare for the future. If they are fearful of the future, then they will not invest money in new ideas or machinery

Question 34

how does the demand for exports influence the level of investment?

Answer 34

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 this extra demand. This will have a knock-on effect and encourage other firms to increase their investment.

Question 35

how does the interest rate influence the level of investment?

Answer 35

Most investment is done through borrowing. High interest rates mean that borrowing is more expensive, so a business needs to be more confident of good profits in order to cover the extra costs of borrowing. Other investment is done through retained profits or savings. A rise in interest rates increases the opportunity cost of a business using retained profits as they are able to get higher interest payments than before.

Question 36

what is the Keynes marginal efficiency of capital graph?

Answer 36

Keynes’ Marginal Efficiency of Capital (MEC) graph shows how higher interest rates will lead to a fall in investment. This displays the expected rate of return from an investment at a particular given time. If interest rate is at 10% then firms need an expected rate of return which is at least equal to 10% to make it worthwhile.

Question 37

how does the influence of government and regulation affect the level of investment?

Answer 37

Governments can encourage investment by their own policy decisions. For example, they could offer tax breaks or grants to businesses to try and encourage them to invest. Regulations also affects investment as a highly regulated economy tends to see less investment as regulation increases the cost and time taken to invest, such as planning regulations.

Question 38

how does access to credit influence the level of investment?

Answer 38

Investment will be lower when an investment has a high risk attached to it, as it means there will be less access to credit and interest rates will be higher. In recessions, it is usually more difficult to access credit as risks are higher and banks become more risk aware, fearing firms will not be able to pay the money
back.

Question 39

how does retained profits influence the level of investment?

Answer 39

Not all firms, particularly small firms, take into account the opportunity cost of investment from their retained profits i.e. the interest gained from keeping it in a bank account. Many firms are also unwilling to borrow
money for investment in case the investment fails to make a profit and they are unable to pay it back. Therefore, if firms are making higher retained profits,
investment is likely to increase as they have money available to invest.

Question 40

define retained profits?

Answer 40

Retained profits are the profits kept by a firm and not shared with shareholders or used to pay taxes.

Question 41

how does technological change influence the level of investment?

Answer 41

Improvements in technology will improve or speed up
production which will increase the level of profitability, meaning the investment has a better prospect of success. Change also means businesses need to invest to keep up with the best technology.

Question 42

how does the costs influence the level of investment?

Answer 42

A rise in the cost of any capital project increases the level of risk that you are taking and therefore leads to lower levels of investment. Also, rises in the costs of
making goods, such as the raw materials and wage, will decrease investment as it will reduce profitability. This means firms have less money to invest and decreases the rate of return on their investment.