2.2 - aggregate demand Flashcards
What is Aggregate Demand (AD)?
Aggregate Demand is the total planned real expenditure on a country’s goods and services produced in an economy.
What are the components of Aggregate Demand?
AD consists of:
• Household’s total expenditure on goods and services (C)
• Firm’s spending on capital goods and the value of changes in stocks (I)
• Government spending on public services (G)
• Exports of goods and services (X)
• Minus Imports of goods and services (M)
How is the AD formula expressed?
AD = C + I + G + (X - M), where C + I + G represents domestic demand, and (X - M) is net exports (trade balance).
What does the AD curve show?
The AD curve shows the relationship between aggregate demand and the general price level in an economy.
What effect does a fall in the general price level have on AD?
A fall in the general price level causes an extension of AD.
What effect does a rise in the general price level have on AD?
A rise in the general price level causes a contraction of AD.
What is the Real Income Effect in the AD curve?
As the price level falls, the real value of income rises, allowing consumers to buy more goods and services (C).
What is the Balance of Trade Effect in the AD curve?
A fall in a country’s price level makes foreign goods more expensive, raising exports (X) and lowering imports (M).
What is the Interest Rate Effect in the AD curve?
If inflation is low, interest rates may fall to increase economy further, reducing the incentive to save, raising consumption (C), and possibly depreciating the currency, boosting net exports (X - M); vice versa if price inflation is high, increase in interest rates to reduce borrowing
What causes shifts in the AD curve?
Shifts in the AD curve occur due to changes in AD components (C, I, G, X, M) that are independent of the general price level.
What is the multiplier effect on AD?
The multiplier effect means that changes in AD can lead to larger increases or decreases in total demand across the economy.
What is disposable income?
Disposable income is the income that households have to devote to consumption and saving after they have paid any direct taxes and received any transfer payments
What is discretionary income?
Discretionary income is household disposable income after unavoidable expenditures.
What is the average propensity to consume?
The average propensity to consume shows the ratio of total spending to total income.
How much of AD does household consumption represent?
Household consumption makes up 60% of AD.
How does disposable income affect consumption?
Higher disposable income increases consumption.
How does job security affect consumption?
Greater job security increases consumer confidence and consumption.
How do savings affect consumption?
Higher savings often indicate lower consumer confidence; less saving usually means higher current consumption. Higher consumption reduces savings; can flow into financial markets and business can access funds to invest
What is the Paradox of Thrift?
The Paradox of Thrift states that increase in saving decreases economy activity, causing a decrease in overall saving as people’s income reduces as incomes fall.
