2.2 Aggregate demand Flashcards
Aggregate Demand (AD)
Total level of planned expenditure on the goods and services produced within a country at a given price level.
The components of aggregate demand
- Consumption (C) - household spending on finished goods and services.
- Investment (I) - gross investment spending on finished goods and services.
- Government spending (G) - government spending by private firms
- Exports of goods and services (X)
- Imports of goods and services (M)
AD formula
C + I + G + (X - M)
AD is downward sloping because
At a lower price level, economic agents will demand more goods and services because it is more affordable.
Consumption
Consumer spending on finished goods and services; it makes up about 60% of AD, so is the biggest part.
Disposable income
The money consumers have left to spend, after taxes have been taken away and any state benefits have been added.
The most important determinant of consumption.
Marginal Propensity to consume (MPC)
The proportion of disposable income that consumers spend on comsumption.
(SRAS) Short run aggregate supply
Total supply of domestic goods and services in the economy at a given price level.
SRAS slopes upwards because
At a higher price levels firms can make more profit. And are willing to produce more.
Causes Fall in AD
- Fail in exports
- Cut in government spending
- Higher interest rates
- Decline in household wealth
Causes Increase in AD
- Depreciation of the exchange rate
- Cuts in direct and indirect taxes
- Increase in house prices
- Expansion of supply of credit + lower interest rates
Household saving
Saving is household disposable income that is not spent.
Savings/disposable income x 100
A higher savings ratio will reduce consumption and ceteris paribus, aggregate demand will fall too.
Interest rates
The cost of borrowing and the reward for saving, expressed as a percentage.
If interest rates are high, then more people will save and less people will borrow, therefore the savings ratios should rise and the marginal propensity to consume should fall, this will lead to a reduction of consumption.
Consumer confidence
If people are confident about the future and expect pay rises, then they will continue to increase their spending.
If they expect inflation in the future, they may buy now as it will be at a cheaper price, so consumption will increase.
However - If they expect a recession and fear possible unemployment, consumption will decrease as people may save more.
Wealth effect
The value of assets someone owns.
The most valuable asset most people will ever own will be a property.
If wealth increases in value, owners of wealth tend to spend more so consumption rises, this is known as own as the wealth effect.
Investment Spending
Represents firms spending to support current output and increase production capability.
It may include spending on new capital assets such as equipments, facilities and raw materials.
Depreciation
The value of capital stock depreciates over time as it wears out and is used up.
Gross investment - investment before depreciation
Net investment - gross investment minus depreciation
Factors which can change the level of investment in a country
-A change in the cost of capital - eg. An increase in the cost of capital will lead to a fall in investment.
-Level of firms profits - if firms have higher profits, then they may have more to invest each year.
-Technological change - If new technology is invented, firms will want to invest more.
-Expectations and business confidence - Economist Keynes believed this was very important. Keynes termed it “animal spirits”
-Government policy - eg. The govt could have tax breaks for firms to increase investment. Regulations also affects investment as highly regulated economy tends to see less investments as regulation increases the cost and time taken to invest, such as planning regulations.
Access to credit - If banks are more willing to lend money, investment will be easier, similarly if interest rates fall investment will rise.
Demand for exports - If the world economy is booming, demand for exports is likely to increase and therefore exporting firms’ investment is likely to increase.
Government expenditure
The government has a very significant part to play in the level of AD, through spending. They spend more money on defence, education, the NHS etc.
Government spending makes up around 25% of AD
Government spending levels are dictated by fiscal policy and the trade cycle.
Fiscal Policy
Government Spending and taxation
The government can vary what they spend each year, and how much they tax each year and this is set out in their budget in October.
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.
Net Trade (X-M)
Exporting goods abroad brings money into the country as there is an increase in AD whilst importing goods mean money leaves the country.
Net trade is the value of total exports minus the value of total imports.
Factors that determine Net Trade: Real income, exchange rates, state of world economy, degree of protectionism, non-price factors and prices
Real income
When real income in the UK is high, there tends to be increased in imports as people demand more goods and services from abroad.
Real income = income adjusted for inflation
Exchange rates
(SPICED) A strong pound makes imports cheaper 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.
State of world economy
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.
Degree of protectionism
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.
Non-price factors
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 British goods instead of foreign goods.
Prices
High prices of UK goods will mean that the good are less competitive to international goods since people will make decisions partly based on price. This means the volume of exports will decrease and the volume of imports will increase.
Determinant factors of consumption
Disposable income, household saving, interest rate, consumer confidence, wealth effects
Gross investment
Refers to the total expenditure on new capital goods.
Net investment
Refers to new additions to capital stock after taking into account the fall in value of capital assets.
