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Macroeconomics Edexcel A (Theme 2 and Theme 4) > 2.2 Aggregate Demand > Flashcards

2.2 Aggregate Demand Flashcards

1
Q

What is AD?

A

The total level of spending in the economy at any given price

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2
Q

What are the components of AD?

A
  • Consumption
  • Investment
  • Government Spending
  • Net Exports
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3
Q

AD formula

A

AD = C+I+G+(X-M)

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4
Q

What is Consumption?

A
  • Consumer spending on goods and services
  • It makes up about 60% of AD
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5
Q

What is investment?

A
  • Spending by businesses on capital goods, such as new equipment and buildings as well as working capital
  • Makes up about 15 - 20% of AD
  • Mostly in the private sector
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6
Q

What is Government spending?

A
  • Spending by the government on providing goods and services, generally public and merit goods, both on wages and salaries of public sector workers and on investment goods like new roads and schools
  • Tends to be around 18-20% of GDP
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7
Q

What are Net Exports?

A

Exports minus imports

5% of AD

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8
Q

AD Curve

A
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9
Q

What are the four key reasons for the AD curve being downward sloping?

A

(As a rise in prices causes a fall in real GDP)

  • Income effect
  • Substitution effect
  • Real balance effect
  • Interest rate effect
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10
Q

Explain the income effect

A
  • 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 in demand
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11
Q

Explain the Substitution effect

A
  • 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
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12
Q

Explain real balance effect

A
  • 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
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13
Q

Explain interest rate effect

A
  • 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
  • Meaning businesses invest less, so AD will contract
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14
Q

A movement along the AD curve is caused by …..

A

a change in prices caused by inflation or deflation

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15
Q

A shift of the AD curve is caused by a ….

A

change in any other variable

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16
Q

What is disposable income?

A
  • The money consumers have left to spend
  • After taxes have been taken away and state benefits have been added
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17
Q

What is Marginal Propensity to Consume (MPC)?

A

A measure of the proportion of an increase in income that a person or household is likely to spend on goods and services rather than save

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18
Q

What is the likely MPC of an average person?

A
  • 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
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19
Q

Why do some people have an MPC of more than 1?

A
  • They use borrowing or savings to fulfil the demand for goods which is higher than their increase in income
20
Q

Why do poorer people tend to have a higher MPC?

A
  • As they are likely to spend much more of their increase in income
  • Whilst rich people are more liekly to save it
21
Q

Formula for MPC

A

MPC = Change in consumption / change in income

22
Q

Formula for APC

A

Total consumption / Total income

23
Q

Explain the relationship between savings and consumption

A
  • An increase in consumption decreases savings so the same factors which affect consumption are those which affect savings - but in the opposite way
  • e.g. a rise in confidence will decrease savings
24
Q

What is the Marginal Propensity to save (MPS)?

A

How much of an increase in income is saved

25
Q

What is the Average Propensity to Save (APS)?

A

The average amount saved out of income

26
Q

Formula of MPS

A

Change in savings / change in income

27
Q

Formula for APS

A

Total savings / total income

28
Q

Explain how interest rates influence consumer spending

A
  • Most major expenditures are bought on credit so therefore the interest rate will affect the cost of the good for consumers
  • If interest rates are high, the price of the good will be 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
  • A rise in interest rates decreases the value of shares and so people experience a negative wealth effect
29
Q

Explain how Consumer confidence influences consumer spending

A
  • If people are confident about the future and expect pay rises, then they will continue or increase 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
  • Expectations about a change in the taxation level will affect consumption: if consumers expect tax to increase prices in the future, they will buy now whilst if they expect it to reduce prices in the future, they will delay their purchases
30
Q

Explain how Wealth effects influence consumer spending

A
  • People with greater wealth tend to have a greater level of consumption, known as the wealth effect
  • The wealth effect is experienced when real house prices rise as owners now 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 can also be experience when share prices rise as people may sell some of their shares and spend the money or may be more confident in spending the money they have as they know they have the shares to fall back on incase of financial difficulty
  • Greater wealth will improve a consumer’s confidence and thus lead to greater spending
31
Q

What is Gross investment?

A

The amount of investment carried out and ignores the level of depreciation

32
Q

What is net investment?

A

Gross investment minus the value of depreciation

33
Q

Explain how the rate of economic growth influences investment

A
  • In a growing economy, there will be higher levels of investment as business would be more confident about their investments and the higher demand would lead to a higher return rate on the investment
  • A growing economy needs more investment in order to cope with the higher levels of demand
  • If the demand is just maintained, investment will stay the same as the firms only have to replace old machines
  • If the level of demand is shrinking, firms will not need to replace their old machines and so investment will fall
34
Q

Explain how Business expectations and confidence influences investment

A
  • When firms are confident about the future and expect further growth, investment will increase as they want to prepare for the future
  • If fearful of the future, then they will not invest money in new ideas or machinery
35
Q

Summarise ‘Animal Spirits’

A

Keynes used the term to describe the feeling of managers and owners of firms on whether their investment would be profitable

He argued that it is difficult to measure

36
Q

Explain how demand for exports influences exports

A
  • 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
37
Q

Explain how interest rates influence consumption

A
  • 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
  • A rise in interest rates increase the opportunity cost of a business using retained profits as they are able to get higher interest payments than before
  • 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.
38
Q

Explain how the influence of government and regulations affect investment

A
  • Governments can encourage investments 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.
39
Q

Explain how access to credit influences investment

A
  • 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.
40
Q

Explain how the trade cycle influences government expenditure

A
  • 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.
41
Q

Explain how Fiscal policy influences government expenditure

A
  • 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.
42
Q

Explain how real income influences net trade balance

A
  • 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
43
Q

Explain how Exhange rates influence net trade balance

A
  • 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. If imports are price elastic, a rise in price will cause a large fall in demand so the value of imports will fall. If imports are inelastic, a rise in price only leads to a small fall in the amount of imports so the value of imports will rise.
  • This is the same for exports: if prices rise and PED is inelastic then there will be a rise in value but if they are elastic then it will cause a fall in value. If both imports and exports are elastic, a rise in the value of the pound will lead to a fall in net trade.
44
Q

Explain how the state of world economy influences net trade balance

A
  • 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.
45
Q

Explain how the degree of protectionism influences net trade balance

A
  • 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.
46
Q

Explain how non-price factors influence net trade balance

A
  • 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.
47
Q

Explain how prices influence net trade balances

A
  • High prices of UK goods will mean that goods are less competitive compared to International goods since people make decisions partly based on price
  • Hence volumes of exports will decrease and the volume of imports will increase

Macroeconomics Edexcel A (Theme 2 and Theme 4) (16 decks)

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