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
level of savings (C)
the more saved the less spent.
Gross vs Net investment
Gross investment is the amount of investment carried out and ignores the level of depreciation, whilst net investment is gross investment minus the value of depreciation.
investment
putting money somewhere to get a reward
Capital investment
this is spending on capital goods such as plants, equipment and mew buildings to produce more consumer goods in the future
what does 45% of investment go to?
training workers
factors that determine investment
-interest rates
-retained profits
-confidence
-technological change
-value of machine
-risk related to investment
-tax and government policy
-economic growth
-accelerator theroy
Rate of Interest (I)
-Higher interest rates means lower investments and vice versa. This is with the assumption that firms use loans to pay for investment
Interest rates
cost of borrowing/return on savings. Set by the Bank of England monetary committee.
Depritiation of Assets
the value of assets decreasing due to second hand, wear and tear and breakdowns
How long does it take for interest rates to have an impact?
18 months
How much of investment is funded by retained profit?
70%
Retained profits (I)
The more retained profits a firm has the higher their level of investment.
-It’s the cheapest option as you don’t pay interest
accelerator theroy (I)
-as output increases, investment will increase, but investment will at an accelerating rate
economic growth (I)
-as the economy grows, investment will increase.
Cost of Machine (I)
-as cost decreases, investment increases
technological change (I)
-if a new, improved machine arrives in a market, investment increases. However, if the rate of change is too quick, there may be a delay in investment.
consumer confidence (I)
-as consumer confidence increases, investment will increase
business confidence (I)
-as business confidence increases, investment will increase.
risk related to investment (I)
-the higher the risk, the less investment there is
government policy (I)
-subsidies, used to invest in new technology
-setting interest rates
-setting taxes such as VAT and corparation tax
Factors that determine governement spending
-trade cycle
-fiscal policy
-age distrinution of policy
why do the government spend?
to reduce market failure
Trade Cycle (G)
-Decisions over government expenditure may be made in order to manage AD, and therefore regulate the trade cycle. In a recession, the government may increase spending in order to increase demand to reduce unemployment.
-Government spending also automatically rises during a recession as they have to spend more on unemployment benefits. During booms, the government may decrease spending to decrease demand and reduce inflation.
Fiscal Policy (G)
-Some government spending is fixed from year to year, for example schools must be funded and pensions must be paid. However, governments can vary what they spend each year, and this is set out in their budget.
-Fiscal policy is the decisions about government spending and taxes and it will depend on the priorities of the government. The level of government spending depends on what they lay out in their fiscal policy.
Age distrubution of the population (G)
An ageing population leads to increased government expenditure on pensions, social care etc. whilst a young population leads to increased spending on education. The more dependents in the economy (the young and old), the higher government spending tends to be.
Deficit vs Debt
When the governement spends more than it recieves, this is the deficit. Adding all of the yearly deficit up is government debt.
Government Spending eval point
As GDP falls, government spending appears worse, becuase they are spending the same but output decreases.
Factors that impact the Trade Balance
-real income
-exchange rates
-state of the world economy
-degree of protectionism
-non-price factors
-price
Real Income (X-M)
When real income in the UK is high, there tends to be increased imports as people demand more goods and services and the UK is unable to meet their needs. This will mean that net trade decreases. However, if an increase in real income is due to export-led growth then net trade will increase. Therefore, the effect of changes in real incomes is dependent on many factors.
Exchange Rates (X-M)
A strong pound (when the pound is worth a lot in comparison to other countries) makes imports cheap and exports dear because it costs foreigners more to buy pounds with their local currency. As a result, imports will increase and exports will decrease so net trade will decrease. This depends on the elasticity of imports and exports
State of the world economy (X-M)
If the UK’s main export country is doing well, then UK exports are likely to rise and so net trade is likely to rise. The effect of the state of the world economy is dependent on which countries are doing well and the trade relationship the UK has with them.
Degree of protectionism (X-M)
Protectionism is an attempt to prevent domestic producers suffering from competition abroad. Tariffs, quotas and technical barriers are introduced which makes it harder for producers from abroad to sell their goods in
the UK. If there is high protectionism on UK exports in other countries, exports will decrease as it will be harder for UK firms to sell their goods in other countries. If there
is high protectionism on imports into the UK, imports will decrease. If the UK imposes protectionist measures, other countries are likely to retaliate and therefore exports are likely to decrease. Free trade means that net trade will be a more significant part of AD, whether this be in a positive or negative sense.
Non-Price Factors (X-M)
Two non-price factors which affect net trade are quality and design and marketing. If UK goods are of a higher quality and design, exports will be high as foreign demand for UK goods will increase and imports will decrease as
people will buy the British goods instead of foreign goods. This means net trade will increase. If UK goods are well marketed, people will have a stronger desire to buy
British goods so exports will increase and imports will decrease, so net trade will increase. Strong quality/design and marketing will mean that British exports are likely
to be more inelastic.
Prices (X-M)
High prices of UK goods will mean that the goods are less competitive compared to international goods since people make decisions partly based on price. This means the volume of exports will decrease and the volume of imports will increase Prices are affected by the inflation rate: if the UK inflation rate is higher than other countries, prices will rise faster. They are also affected by productivity in UK (output per worker) as higher productivity leads to lower costs and so prices will be
low. The effects of changing prices on the value of imports and exports depends on the price elasticity of demand. If PED is elastic, then higher prices will lead to a fall in
net trade.
SPICED
Strong
Pound
Imports
Cheap
Exports
Deer –> expensive
three types of spending
-capital
-current
-transfer payment
Capital spending
new public infrastructure
Current spending
providing public services
transfer payments
benefit system used to reduce inequality
