2.2 Aggregate Demand Flashcards
Defintion of AD
the total level of spending in the economy at any given price
Equation for AD
AD=C+I+G+(X-M)
Consumption (C)
Consumer spending on goods and services; it makes up about 65% of AD, so is the biggest part.
Investment (I)
Spending by businesses on capital goods, such as new equipment and buildings as well as working capital e.g. stocks and work in progress; it makes up about 15% of AD.
Government Spending (G)
Spending by the government on providing goods and services, generally public and merit goods. This will change year on year as governments decides how much they spend. Transfer payments such as pensions and jobseekers’ allowances aren’t included in the figure as money is just transferred from one group to another. Government spending tends to be around 25% of GDP.
Exports-Imports (X-M)
When imports are higher than exports this is a minus figure as more money leaves the UK than comes in. The UK has a large trade deficit, AD at around -5%
What does the AD curve show?
It shows the relationship between price
level and real GDP. A rise in prices causes a fall in real GDP
Four factors that causes a rise in
prices causes a fall in real GDP.
1) Income effect
2) Substitution effect
3) Real Balance effect
4) Interest Rate effect
Income effect
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.
Substitution effect
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.
Real Balance effect
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.
Interest Rate effect
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.
Factors that influnece consumption
-Disposable Income
-Relationship between savings and consumption
-interest rates
-consumer confidence
-wealth effects
-avalibility of credit
-composition of household
-unemployment levels
-level of saving
Disposable Income
-The money consumers have left to spend, after taxes have been taken away and any state benefits have been added. This means that disposable income is affected by government taxation as well as wages. Those who are earning a large income will be able to spend much more than those on a minimum wage.
Disposable income Evaluation
-we are also concerned with how much an increase in income affects consumption, this is called the marginal propensity to consume (MPC). For most people, MPC will be positive but less than 1 i.e. an increase in income increases spending but spending doesn’t increase by as much as income.
-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
marginal propensity to consume (MPC)
how much an increase in income will imoact consumption
MPC equation
change in income
what does MPC + MPS equal
1
marginal propensity to save (MPS)
how much of an increase in income is saved whilst the average propensity to save (APS) is the average amount saved out
of income.
MPS equation
change in income
Relationship between savings and consumption
Savings is what is not spent out of income. An increase in consumption decreases savings so the same factors which affect consumption are those which affect savings- but in the opposite way. For example, a rise in confidence will decrease
savings.
Interest rates (C)
a decrease in interest rates leads to an increase in spending and economic growth
consumer confidence (C)
As confidence increases, consumption increases
avalibilty of credit (C)
increased avalibilty of credit, leads to an increase in spending
composition of household (C)
16-25 and elderly spend the most
unemployment levels (C)
as unemployment increases, consumption decreases