2.2 Aggregate Demand Flashcards
What is AD?
the total demand for all goods/services in an economy at any given average price level?
How is AD calculated?
AD = Consumption (C) + Investments (I) + Government Spending (G) + Net Exports(Exports - Imports)(X-M)
What happens if AD increases?
economic growth occurs
What is consumption?
total spending on goods/services by consumers in an economy
What is investment?
the total spending on capital goods by firms
What is government spending?
total spending by the government in the economy
- includes public sector salaries, payments for provisions of merit and public goods etc.
What is are net exports?
the difference between the revenue gained from selling goods/services abroad and the expenditure on goods/services from abroad
What is the % that each component contributes to AD in the UK approx?
consumption - 60%
investment - 14%
government spending - 25%
net exports - 1%
Why is the AD curve downward sloping?3
- the interest rate effect
- the wealth effect
- the exchange rate effect
What is the interest rate effect?
- At higher average price levels, there are likely to be higher interest rates.
- higher interest rates reduce investments and are an incentive for households to save and vice versa
What is the wealth effect?
- as average price increases
- the purchasing power of household decreases
- and AD falls
(and vice versa)
What is the exchange rate effect?
- As average price falls
- interest rates are likely to fall too
- lower interest rates lower the exchange rate
- lower exchange rate causes economies goods/services are more attractive abroad and exports increase
- thereby increasing real GDP
When does the AD curve shift?
when the components of AD experience a change
What is disposable income?
the only households have left from their salary/wages after they have paid their taxes and have received any transfer payments/ benefits
What can cause disposable income to change? 3
- if tax increases, disposable income falls
- if wages fall, then disposable income decrease
- if transfer payments to a household increases, then disposable income increases
What is the relationship between disposable income and consumption?
- consumption increases as disposable income increases
- consumption decreases as disposable income decreases
What is the relationship between savings and consumption?
disposable income can be saved or spent on goods/services (consumption)
- savings decrease, consumption usually increases
- savings increase, consumption usually decreases
What is the household savings ratio?
calculates households savings as a proportion of household income
- usually low when an economy its booming and full of confidence
What are some examples of influences on consumer spending?3
- changes to interest rates
- changes to consumer confidence
- changes to wealth
How do changes to interest rates influence consumer spending?
- interest rates are set by government central bank that cause commercial banks to change the lending and saving rates they offer
- changes cause changes to the level of consumer spending and savings
- if interest rates increase a greater incentive to save occurs thus less consumption
- if interest rates increase, the monthly repayment on any loan or mortgage increases. these higher loan repayments cause less consumption
What is the relationship between consumer confidence as an influence on consumption?
- stronger the economy, the higher the consumer confidence
- consumers feeling secure in their jobs are confident of receiving regular salary payments thus consumption increases and saving decreases
- in a weakening or recessionary economy, confidence falls
- consumers feel less secure in their jobs thus consumption decreases and saving increases
How do changes to wealth influence changes in consumption?
if consumer wealth increases consumption increases
- rising property prices or share truces give consumer confidence to borrow moe money
increased borrowing leads to increased consumption
What is investment?
total spending on capital goods by firms
- helps to increase the capacity of an economy
- increased capacity (PPF) leads to increased potential economic growth
What is depreciation?
the decrease in monetary value of a capital good over time
- replacing old capital goods does not necessarily increase capacity
What is gross investment?
the total amount of spending on capital goods
- spending includes replacing olds capital goods and purchasing new capital goods
What is Net investment?
gross investment - depreciation
- provides information on the addition of new capital goods to an economy
- gives a better indication of the extra production possibilities that have been created through investment firms.
Why do firms invest?2
- if they feel confident that they will make a good return on their investment
- decision is linked to the business objective of profit maximisation
What are the 4 key influences on the decision by firms to invest?
- rate of economic growth
- interest rates
- demand for exports
- influence of government & regulation
Why is the rate of economic growth an influence of investment?2
- increasing growth sends a signal that higher output will generate higher profits
- the faster the economic growth, the greater the urgency to invest
Why are interest rates a key influence on investment?
- most investment by firms is financed through business loans
- decreasing interest rates encourage investment
- mostly an inverse relationship between investment and interest rates
Why is demand for exports a key influence on investment by firms?3
- demand for exports increases, firms will likely invest to meet the global demand
- demand for exports can increase if the exchange rate depreciates
- goods/services are cheaper to foreigners
Why is the intervention of government & regulation a key influence on investment by firms?2
- government intervention can increase investment. e.g. subsidies
- government regulation can decrease investment as It raises the cost of production for firms and can lower foreigners
What are 3 other influences on investment?
- business expectations and confidence
- keynes & animal spirits
- access to credit
How do business expectations and confidence influence investment?
- the longer a period of economic growth, the higher the confidence would be
- if growth slows, future expectations of profits will decrease and investment decisions become harder
How is Keynes & animal spirits influences on investment?
- Keynes believed firms exhibit too much optimism in the good times and take too many risks
- they run with the mood of the economy and make less rational investment decisions
How does access to credit influence investment?
- easier the access to loanable funds, the higher the levels of investment.
- some developing economies have low access to credit and this holds back investment
What is government expenditure?
influenced by the trade cycle
- spending linked to achieving policy aims
- can help on a local level or a national level
What are the influences on government expenditure?3
- the trade cycle
- fiscal policy
- age distribution of the population
How does the trade cycle influence government expenditure? 1+3
decisions over government expenditure may be made in order to manage AD thus regulating 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 benfits
- during booms the government may decrease spending to decrease demand and reduce inflation
How does fiscal policy influence government expenditure?
- some govt spending is fixed however this can be changed annually, set out in government budgets
- the level of government spending depends on what they lay out in their fiscal policy
What is fiscal policy?
the decisions about government spend and taxes, dependent on the priorities of the government
How does the age distribution of the population influence on government expenditure?
- ageing population leads to increased government expenditure
- whilst a young population leads to increased spending education
- the more dependent in the economy, the higher government spending tends to be.
What is the net trade balance?
- difference between the value of the exports and imports (X-M)
What are net trade balance influenced by? 4
- changes to real income
- exchange rates
- state of the world economy
- degree of protectionism
How does UK real income increasing effect exports & imports?
- little effect on exports
- consumers purchase more imports
- trade balance weakens
How does real income increasing abroad effect exports & imports?
- foreigners purchase more UK products, exports increase
- little effect on imports
- trade balance strengthens
How does UK £ appreciating effect exports & imports?
- exports more expensive for foreigners, exports decrease
- consumers money goes further abroad, imports increase
- trade balance weakens
How does UK £ depreciating effect exports & imports?
- exports less expensive for foreigners, exports increae
- consumers money is worth less abroad, imports decrease
- trade balance strengthens
How does the world economy booming effect exports & imports?
- increased demand for UK exports
- little effect on imports
- trade balance strengthens
How does the world economy depressing effect exports & imports?
- decreased demand for UK exports
- little effect on imports
- trade balance weakens
How does protectionism increasing effect exports & imports?
- depends on retaliation measures from other countries
- decreased demand for imports as they are more expensive
- trade balance strengthens
How does protectionism decreasing effect exports & imports?
- likely to increase exports
- increased demand for imports as they are less expensive
- trade balance weakens
