2.2 Aggregate Demand Flashcards
formula for AD
C+ I+G +(X-M)
4 reasons why AD curve is downward sloping
- Income effect
- Substitution effect
- Real balance effect
- Interest rate effect
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.
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.
Using the LRAS curve, what will happen in the long run to real output if AD increases.
- There would be no change in real output
- Since classical economists believe the economy will be at full employment in the long run
Explain the shape of the classical LRAS curve
Economy operates at full capacity/ no spare capacity, so there are no unsused factors of production.
What is meant by spare capacity in the economy
- Under-utilisation of factors of production
- So there is room to increase supply
Keynesian consumption function formula.
C= a + bYd
Explain keynsian consumption function
At low incomes, people will spend a higher proportion of their income beacuse they have less to save (spend more on necessities)
As incomes rise, people can afford the luxury of saving a higher proportion of their income
Spending ↑ at a lower rate than disposable income
High incomes= low APC
Milton Friedman
Permanant income hypothesis/ Rational expectation theory
People consume based on their future predicted income
* If income tax decreases, consumption wouldnt ↑ as a result of people knowing that its temporary and will rise again
* A persons assets determine their permanant income eg wealth
Equation for permanent income hypothesis
C=KyP
K= constant average and MPC
P= permanent income
Life cycle hypothesis
At low incomes people have ↑ MPC
High incomes = ↑MPS
older people save more as they have their peak income
Define MPC
The proption of one additional unit of income that is spent
MPC= change in C / change in Y
Define disposable income
The money consumers have left to spend after taxes have been removed and state benefits have been added
Effect of cutting interest rates on consumption
- Cost of borrowing falls
- Rate of return on saving falls
- Increase incentive for consumer to borrow money and spend more on luxury items
- ↑ in consumption
most major expenditures are bought on credit
Effect of low consumer confidence
If for some reason consumer confidence declines, consumers become less certain about their financial prospects, and they begin to spend less money; this in turn affects businesses as they begin to experience a decrease in sales.
Definition: stock of assests eg house, share prices and bond
Describe positive wealth effect
If prices increase and individuals hold assets like houses, shares and bonds, they feel wealthier
Own more wealth= ↑C as they know if they go into financial difficulty they could borrow more against their house
House is worth more than mortgage
This improves consumer confidence
Define negative equity
Outstanding mortgage balance exceeds the value of the property, creating challenges for borrowers and lenders alike.
Tax on business profit
How does reduced corporation tax affect investment
Retained profit- profit left after corporation tax has been paid
Decreasing CT= ↑ levels of retained profit
Greater potential for business to invest
Have more RP to fund on capital goods
Most investment by firms is financed through business loans
How does interest rates affect investment
If I.R. in economy falls, cost of borrowing falls
Firms have greater incentive to borrow money and invest = MPI↑
Keynes marginal effiency of capital shows increasing I.R. decreases MPI
What is the notion of the hurdle
Hurdle: required rate of return that firms need for investment projects to go ahead
Decreasing I.R. makes reaching the hurdle easier
MPI↑
How does a rise in I.R. affect mortgage interest repayments
Rise in mortgage interest repayments will reduce homeowners’ real “effective” disposable income.
Increase in mortgage costs would reduce market demand in housing market, reducing inflation
How does a rise in I.R. affect (X-M)
Higher interest rate increases the value of pound due to hot money flows; (X-M) component of AD falls, reducing inflationary pressures
How might a decrease in real incomes influence level of savings
Fall in income is likely to reduce savings leading to a fall in the marginal propensity to save
How might a decrease in unemployment influence level of savings
Lower unemployment is likely to cause a rise in consumer spending due to greater disposable incomes, leading to fall in savings ratio
Factors affecting savings
- Income
- Unemployment
- Consumer confidence
- Interest rates
3 marks
Effect of appreciation of the British £
- An appreciation means that £1 becomes worth more than US dollars
- The British £ of G+S imported from US will be lower
- The US dollar of G+S exported from UK will be higher
How would low productivity worsen the trade deficit.
This would have reduced the price-competitiveness of UK exports because output per unit input is lower, increasing average labour costs. This would reduce demand for the UK’s relatively more expensive exports, worsening the trade deficit.
Effect of a rise in exports through increased international trade
- Exports are a component of aggregate demand.
- Real GDP will increase
- Actual economic growth with occur, as businesses respond to rising demand from overseas
