2.2 - Aggregate demand Flashcards
What is aggregate demand?
The total value of planned expenditure on goods and services produced in an economy in a given period of time
What are the components of aggregate demand? What are the percentages?
- AD=C+I+G+(X-M)
- C = 60%
- I = 14%
- G = 25%
- (X-M) = 1%
What is the distinction between a movement along, and a shift of, the AD curve?
- Movements along the AD curve are caused by a change in the average price level (inverse relationship) - a rise in the average price level leads to a contraction of AD
- AD shifts because of a change in any of consumption, investment, government spending, exports or imports. This can be caused by changes in behaviour or changes in government policy
What can a change in average price level lead to?
Changes in average price level can lead to several things:
- Real incomes: A rise in the average price level can lead to the real value of income to drop.
- Balance of trade: If the average price level of a foreign country fell, domestic consumers would demand more imports, causing a contraction in AD.
- Interest rates: If the average price level rises, there will be inflation.
What is a demand side shock?
A demand-side shock is anything (positive or negative) that causes AD to change.
Examples of a negative shock could be an interest rate rise, a collapse in the housing market, etc
As well as a fall in real GDP, this could have a knock-on effect on confidence, leading to further falls in activity
What are the features of the AD curve?
- Downward sloping
- Consumption will fall as the price level rises - a movement (not a shift) along the AD curve
What does disposable income and savings mean and what is the importance of the savings ratio? (What is China’s savings ratio (case-study) ?)
- Disposable income is the amount of money that people have left after paying their income taxes.
- An increase in disposable income will lead to an increase in consumer spending
- China = 30%
What is MPC?
Marginal propensity to consume: how much of an increase in household income is consumed or spent
Change in consumption / Change in income
What is the relationship between savings and consumption? (savings ratio)
- Savings is the part of disposable income that is not spent on things like food, clothing and rent.
- The savings ratio is the ratio of savings to income (S/Y)
- If the savings ratio rises, it is likely that consumption will fall. This is because: savings + consumption = disposable income
What other factors influence consumer spending?
- The interest rate
- Level of consumer confidence in the future
- Wealth effects
- Inflation expectations
- Level of income
- Availability of credit
How do interest rates influence consumption? What is the current interest rate?
- If interest rate rises, then saving is more attractive, so consumers will spend less and save more
- Base rate = 4.5%
How does inflation influence consumption? What is the current inflation rate?
- If inflation increases, it will be more expensive to purchase goods and services so consumption will be discouraged
- Inflation = 3% (January)
How does level of consumer confidence in the future influence consumption?
If confidence is low, consumers will spend less and save more.
How does the wealth effect influence consumption?
This happens if asset prices rise and consumers feel as though they have more money. They may spend more if share prices or property prices rise.
How does level of income influence consumption?
People with higher incomes tend to save more: they have a higher marginal propensity to save, that is for every extra pound people get, they save more as they get richer
What is the life-cycle hypothesis?
The theory states that individuals seek to smooth consumption over the course of a lifetime – borrowing in times of low-income and saving during periods of high income.
The graph shows individuals save from the age of 20 to 65:
- As a student, it is rational to borrow to fund education.
- Then during your working life, you pay off student loans and begin saving for retirement
- This saving during working life enables you to maintain similar levels of income during your retirement
How does availability of credit influence consumption?
This refers to how easy it is to borrow money
How do pensions influence consumption? Give real-world examples.
- A decrease in pension payments -> people save up more -> decreased consumption -> decreased AD
- Greek people were previously entitled to a pension worth 80% of earnings - Greek government cut this to 60%
- April 2017 - UK gov increased state pensions from £155.65/wk to £159.55/wk
What is the distinction between gross and net investment?
Gross investment is the total amount that the economy spends on new capital
Net investment = gross investment - capital depreciation
What factors influence investment?
- Rate of economic growth
- Business expectations & confidence
- Keynes’ animal spirits
- Export demand
- Interest rates
- Access to credit
- Government & regulation
- Profitability
- Accelerator effect
How does the rate of economic growth influence investment?
- Usually measured as a % of GDP
- If GDP rises, then investment is likely to rise too
- High economic growth signals economic strength - gives businesses confidence in the future - will invest to increase their productive capacity, expecting increases in demand to continue in the future
How does business confidence and expectations influence investment?
If businesses expect demand for their goods & services to continue rising - likely to invest to increase their productive capacity
How does Keynes’ idea of animal spirits influence investment?
Firms will be overoptimistic and invest excessively in good times, before reducing investment too much when consumer spending is lower and business confidence is weaker
How does export demand influence investment?
A component of aggregate demand - if international demand for a firm/nation’s goods rose, it’s likely they would invest to increase productive capacity
How do interest rates and access to credit influence investment?
- Low interest rates = less debt = more likely to borrow & invest it
- Higher access to credit makes it more likely that firms will be able to borrow to invest
How does the accelerator effect influence investment?
This is when an increase in GDP results in a proportionally larger rise in capital investment spending
How does government and regulation influence investment?
Governments can subsidise or encourage investment in certain industries e.g healthcare
How does profitability influence investment?
If firms have more profits, they have greater funds with which to purchase new capital, expand existing factories
How does the trade cycle influence government spending?
The trade cycle displays a country’s economic growth.
- The fluctuations account for different phases: economic growth, peak, economic downturn & trough
- In an economic boom, there is more spending and higher incomes which means the government receives more tax. The government also pays less benefits.
How does age distribution of a population influence government expenditure?
An ageing population leads to increased expenditure on pensions, social care etc, whilst a younger population leads to increased spending on education. More dependents usually = greater spending
What is fiscal policy?
A government’s policy regarding taxation and public spending to achieve macroeconomic objectives through shifting AD
What is loose fiscal policy?
Increased spending and lower tax revenue to boost economic activity
What is tight fiscal policy?
Cutting spending and raising extra tax revenue, resulting in slower growth
What are automatic stabilisers?
Fiscal policy tools to influence GDP and counter fluctuations in the economic cycle without any deliberate government action, such as changes in tax revenues & welfare spending that vary with GDP
How does fiscal policy influence government spending?
Fiscal policy is the decisions about taxes and government spending 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
What is the net trade balance?
The net trade balance is the difference between the value of the exports and imports
What factors influence net trade?
- Price
- Real income
- Exchange rates
- State of the world economy
- Degree of protectionism
- Non-price factors
(P.R.E.S.D.N)
How do exchange rates influence net trade?
S.P.I.C.E.D - Strong Pound Imports Cheaper Exports Cheaper
W.P.I.D.E.C - Weak Pound Imports Dearer Exports Cheaper
How does the state of the world economy influence net trade?
- If the UK’s main export country is doing well then exports are likely to rise thus net trade will 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
How does the degree of protectionism influence net trade?
Protectionism is an attempt to prevent domestic producers suffering from competition abroad (improve ratio of exports to imports) e.g. tariffs and quotas are physical barriers which make it harder for producers from abroad to sell their goods in the UK
How does real income influence net trade?
When real income is high, MPM tends to increase as people demand more goods and services and the UK is unable to meet their needs - net trade decreases
How do price factors influence net trade?
- High prices of UK goods = less competitiveness compared to international goods = volume of exports decreases and imports increase
- If UK inflation rate is higher than other countries, prices will rise faster
- High productivity = low cost = low price
- If PED is elastic, higher prices = fall in net trade
How do non-price factors influence net trade?
- If UK goods are higher quality, exports will be high as foreign demand for UK goods will increase - imports will also decrease as people opt for British goods
- If UK goods are well marketed, consumers will have a stronger desire to buy British goods - exports will increase, imports will decrease
What are some cyclical causes of a trade deficit?
- Rising real incomes - leads to an increased demand for imports especially goods and services with a high YED
- Increasing consumer spending - perhaps financed by borrowing/debt - as consumption grows (and savings fall) - imports rises
- Expanding production - businesses need to import more raw materials
- Growing investment spending - e.g. large amounts of new capital machinery and technology from overseas
- Strong exchange rate - S.P.I.C.E.D - depends on the price PED for exports and imports -> stronger currency = larger trade deficit
