2.2 Aggregate Demand

Question 1

formula for AD

Answer 1

C+ I+G +(X-M)

Question 2

4 reasons why AD curve is downward sloping

Answer 2

1. Income effect
2. Substitution effect
3. Real balance effect
4. Interest rate effect

Question 3

Interest rate effect

Answer 3

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.

Question 4

Income effect

Answer 4

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.

Question 5

Substitution effect

Answer 5

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.

Question 6

Real balance effect

Answer 6

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.

Question 7

Using the LRAS curve, what will happen in the long run to real output if AD increases.

Answer 7

• There would be no change in real output
• Since classical economists believe the economy will be at full employment in the long run

Question 8

Explain the shape of the classical LRAS curve

Answer 8

Economy operates at full capacity/ no spare capacity, so there are no unsused factors of production.

Question 9

What is meant by spare capacity in the economy

Answer 9

• Under-utilisation of factors of production
• So there is room to increase supply

Question 10

Keynesian consumption function formula.

Answer 10

C= a + bYd

Question 11

Explain keynsian consumption function

Answer 11

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

Question 12

Milton Friedman

Permanant income hypothesis/ Rational expectation theory

Answer 12

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

Question 13

Equation for permanent income hypothesis

Answer 13

C=KyP

K= constant average and MPC
P= permanent income

Question 14

Life cycle hypothesis

Answer 14

At low incomes people have ↑ MPC
High incomes = ↑MPS
older people save more as they have their peak income

Question 15

Define MPC

Answer 15

The proption of one additional unit of income that is spent
MPC= change in C / change in Y

Question 16

Define disposable income

Answer 16

The money consumers have left to spend after taxes have been removed and state benefits have been added

Question 17

Effect of cutting interest rates on consumption

Answer 17

• 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

Question 18

Effect of low consumer confidence

Answer 18

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.

Question 19

Definition: stock of assests eg house, share prices and bond

Describe positive wealth effect

Answer 19

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

Question 20

Define negative equity

Answer 20

Outstanding mortgage balance exceeds the value of the property, creating challenges for borrowers and lenders alike.

Question 21

Tax on business profit

How does reduced corporation tax affect investment

Answer 21

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

Question 22

Most investment by firms is financed through business loans

How does interest rates affect investment

Answer 22

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

Question 23

What is the notion of the hurdle

Answer 23

Hurdle: required rate of return that firms need for investment projects to go ahead
Decreasing I.R. makes reaching the hurdle easier
MPI↑

Question 24

How does a rise in I.R. affect mortgage interest repayments

Answer 24

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

Question 25

How does a rise in I.R. affect (X-M)

Answer 25

Higher interest rate increases the value of pound due to hot money flows; (X-M) component of AD falls, reducing inflationary pressures

Question 26

How might a decrease in real incomes influence level of savings

Answer 26

Fall in income is likely to reduce savings leading to a fall in the marginal propensity to save

Question 27

How might a decrease in unemployment influence level of savings

Answer 27

Lower unemployment is likely to cause a rise in consumer spending due to greater disposable incomes, leading to fall in savings ratio

Question 28

Factors affecting savings

Answer 28

1. Income
2. Unemployment
3. Consumer confidence
4. Interest rates

Question 29

3 marks

Effect of appreciation of the British £

Answer 29

1. An appreciation means that £1 becomes worth more than US dollars
2. The British £ of G+S imported from US will be lower
3. The US dollar of G+S exported from UK will be higher

Question 30

How would low productivity worsen the trade deficit.

Answer 30

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.

Question 31

Effect of a rise in exports through increased international trade

Answer 31

• Exports are a component of aggregate demand.
• Real GDP will increase
• Actual economic growth with occur, as businesses respond to rising demand from overseas