2.2 Aggregate Demand Flashcards
Aggregate Demand
The total level of expenditure in the economy at any given price
Components of AD
AD = C + I + G + (X-M)
Consumption = 60%
Investment = 15-20%
Gov spending = 18-20%
Net exports (X-M) = 5%
Income effect
As a rise in price doesn’t immediately cause a rise in income, people have lower real incomes and therefore spend less, contracting demand
Substitution effect
If prices in uk rise, less foreigners will want to buy UK exports and there will be an increase in imports, decreases net export and therefore AD
Real balance effect
A rise in prices will meant hat the amount people have saved will no longer be worth as much and so will offer less security so people will save more and reduce spending, contracting AD
Interest rate effect
Rising prices mean firms have to pay workers more. Higher demand for money and supply stays the same = higher interest rates so people will save more, contracting AD
Consumption
Spending on consumer goods and services over a period of time
Disposable income
The money consumers have left to spend, after taxes and any state benefits have been taken away.
Determines the level of consumption (most important factor)
Marginal propensity to consume
The increase in consumption following an increase in income (% change in C/% change in Y)
Poorer people tend to have a higher MPC as they are more likely to spend more of their increase in income
Average propensity to consume
The average amount spent on consumption out of total income.
Total consumption / total income
Savings and consumption
Savings is what is not spent out of income. Increase in consumption decreases savings and vice versa
Marginal propensity to save
How much of an increase in income will be saved
% change in savings/% change in income
Average propensity to save
The average amount saved out of income
total savings/ total income
Wealth effect
The gain in consumer confidence as a result of increasing asset prices owned by households
Consumer confidence
The confidence of consumers in determining their marginal propensity to consume.
Influences on consumer spending
Interest rates - if I.R are high, the price of the good will be higher since more interest needs ton be paid back, leading to reduction in consumption and higher I.R will decrease the value of shares and so people experience negative wealth effect
Consumer confidence
Wealth effect
Distribution of income - High income tend to save a higher % of their income. If money is moved from rich to poor, consumption is likely to increase
Tastes and attitudes - if people were less materialistic, consumption would decrease
Investment
The addition of capital stock to the economy used to produce other goods and services
Gross investment
The amount of investment carried out and ignores level of depreciation
Net investment
Gross investment - value of depreciation
Accelerator effect
Influence on I
This is where a change in the demand for goods and services beyond current capacity will lead to an even greater percentage change in I (negative and positive)
Keynes ‘animal spirits’
The instinct and emotions that influence and guide human behaviour
Business expectations and confidence
Determined by levels of AD in the economy
Influences on investment
Rate of economic growth - linked to accelerator effect. If economy is growing, firms will see a greater return on their investment as there is higher demand
High animal spirits and confidence, investment will increase
Demand for X - booming economy = increased demand for exports and therefore increased I to keep up with demand
I.R - high I.R = more expensive to borrow therefore firms may be less willing to invest
Influence of gov and reg - Gov can encourage investment by their own policy decisions e.g tax breaks
Influences on invesment pt2
Access to credit - Investment will be lower when the investment has a high risk attached to it. In recessions its more difficult to access credit as banks are more risk aware
retained profit
Retained profit - if firms are making high retained profits (not split with shareholders), investment is likely to increase as they have money available to invest.
Technological change - Improvements in tech mean that investment has a better prospect of success
Costs - A rise in cost of any capital project increases level of risk therefore, lower levels of investment
Government spending
An injection into the circular flow of income based on current spending (short term e.g wages) and capital spending (long term e.g roads)
Influences on government expenditure
The trade cycle - in recession, there is increased gov spending in order to increase demand, reduce unemployment and pay for unemployment benefits. In booms, decreased gov spending to decrease ad and lower inflation
Fiscal policy - The level of gov spending is dependent on what they lay out in their fiscal policy
Age distribution of population - An ageing population leads to increased gov expenditure on pensions, social care etc whilst younger leads to increased spending on education. The more dependents in the economy, the higher gov spending will be
Exports
An injection into the circular flow of income - income coming in goods going out to other countries
Imports
Leakage from the circular flow of income - income going out from goods coming in from other countries
Influences on net trade balance
High real income leads to increased imports as people demand more goods and services outside of UK, leads to decrease in net trade. However if increase in Y is due to export led growth, then net trade will increase
E.R - Strong pound makes imports cheap and exports dear and therefore imports will increase, so net trade will decrease. However this is dependent of elasticity of imports and exports
State of the world economy - if UKs main export country is doing well then UK exports are more likely to rise and so net trade will rise
