2.2 - Aggregate Demand Flashcards
What is aggregate demand?
The total level of spending in the economy at any given price.
What is AD made up of?
AD = C + I + G + (X-M)
What is the AD curve?
Shows the relationship between price level and real GDP.
A rise in prices will cause a fall in real GDP.
What is price level?
The average of prices for all goods and services in an economy.
What is real national output (RNO)?
The output of the economy taking into account inflation.
How is a rise in price shown on the curve?
A movement up the curve - contraction
How is a fall in price shown on the curve?
A movement down the curve - expansion.
What are the 4 key reasons that a rise in price causes a fall in real GDP?
Income effect
Real balance effect
Substitution effect
Interest rate effect
What is the income effect?
A rise in price is not immediately matched by a rise in income, so lower real incomes mean people can buy less, contracting demand.
What is the real balance effect?
A rise in price means saved up money will be worth less and encourage reduced spending. This also contracts demand.
What is the substitution effect?
If prices rise, less foreigners want to buy British exports.
UK residents will also want to buy imported foreign goods, as they are cheaper.
This will decrease demand for exports, decreasing net exports and reducing AD.
What is the interest rate effect?
When price levels rise, more money is needed for purchases / transactions, increasing demand for money which —> leads to higher interest rates.
This makes borrowing more expensive which encourages reduced spending, reducing aggregate demand.
What is consumption?
Spending on consumer goods and services over a period of time.
Makes up 60% of AD.
What is disposable income?
The money consumers have left to spend after taxes have been taken away.
How does disposable income affect consumption?
The most important factor.
Those with higher income will be able to spend more. Marginal propensity to consume must be considered as higher income does not mean more consumption.
Poorer people are likely to have higher MPC.
How do you calculate MPC?
Change in consumption / change in income
How do you calculate APC?
Total consumption / total income
What are savings?
What is not spent out of income.
What is the relationship between savings and consumption?
As consumption increases, savings decrease.
The factors which affect consumption affect savings in the opposite way.
How do interest rates affect consumption?
When interest rates rise, borrowing for credit becomes more expensive.
It may also increase mortgage repayments, so people have less disposable income overall.
AS INTEREST RATES RISE, CONSUMPTION FALLS
How does consumer confidence affect consumption?
Confidence for the future and expected pay rises means more spending.
Predicted high inflation rates also encourages buying now rather than later, as it is cheaper.
However, if people expect recession and fear unemployment, they will try to save more and consume less.
AS CONFIDENCE RISES, CONSUMPTION RISES
How does wealth affect consumption?
People with greater wealth tend to have greater levels of consumption.
When house prices rise, homeowners feel wealthier as their house is worth more. They tend to borrow more money if needed, increasing consumption,
Rising share prices also makes people feel more financially secure.
AS WEALTH, HOUSE / SHARE PRICES, RISE, CONSUMPTION RISES
How does distribution of income affect consumption?
Those on higher incomes tend to save a higher % of their income, so less consumption.
If money is moved towards the poor, they have higher MPC.
THE POORER HAVE HIGHER MPC, INCREASING CONSUMPTION
How do tastes / attitudes affect consumption?
Society has a strong materialistic drive to encourage people to buy the newest and the best, so spending and consumption is high.
THE NEWER/BETTER THE PRODUCT, THE HIGHER THE CONSUMPTION
What is investment (I)?
Spending by a business on capital goods such as new equipment.
Makes up about 15-20% of AD.
What is gross investment?
The total amount spent on new capital goods.
What is net investment?
This subtracts the amount spent on replacing worn out / outdated capital - known as depreciation.
Net investment = gross investment - depreciation.
How does the rate of economic growth affect investment?
A growing economy, demand is higher so businesses are more confident and want to meet high demand.
They may need to increase machinery, increasing investments.
AS THE ECONOMY GROWS, INVESTMENTS INCREASE
How do business expectations / confidence affect consumption?
If future growth is expected, investments will increase - opposite if recession is feared.
What idea did John Maynard Keynes introduce?
The concept of ‘animal spirits’ - a term to describe the feeling of whether investments are profitable.
How does demand for exports affect investment?
If the world economy is high, demand for exports may increase.
Exporting firms will need to produce more, so more investments.
AS DEMAND FOR EXPORTS INCREASES, INVESTMENTS INCREASE
How do interest rates affect investment?
If interest rates are high, borrowing becomes more expensive so businesses need to be confident about profits.
Businesses may also use retained profits as a form of investment. If they choose to do this when interest rates are high, there is an opportunity cost on the money they could’ve received if they saved their retained profits instead.
How does the influence of the government / regulations affect investment?
Governments may try to encourage businesses to invest things by introducing: tax breaks, which can reduce costs and increase profitability.
Regulations may increase costs + time consumed, discouraging investments.
How does access to credit affect investment?
When risk is high, getting access to credit is more difficult because banks are more risk aware and are more reluctant to lend money as they fear firms won’t be able to pay it back.
LOWER ACCESS TO CREDIT, LOWER INVESTMENTS
How does changes in technology affect investment?
Improvements in technology will improve the production process which increases profitability.
This means the investment has better chance of success.
How do costs affect investment?
Increased costs can reduce profits + cash flow, making it harder to cover expenses.
This creates uncertainty and forced businesses to make riskier decisions, reducing chances of investment.
AS COSTS INCREASE, INVESTMENTS FALL
What is government spending?
Focuses on providing goods + services, wages and salaries, and other infrastructure.
Makes up around 18-20% of GDP.
How does a rise in taxation affect government spending, and in turn AD?
An increase in tax raises government revenue, which allows government to increase spending.
This is based on the governments fiscal policy objectives:
If the government uses the additional tax revenue to increase spending, AD may rise.
If instead they use it to reduce national debt, AD may fall.
What are the potential indirect effects of higher taxation for consumers and businesses on AD?
Higher tax on individuals can reduce disposable income, which can reduce consumer spending.
For businesses, they may be less confident to invest, as they face higher costs.
This can reduce overall AD in the economy.
How does the trade cycle affect government spending?
If the economy is in recession, the government will increase spending on things such as social programmes and unemployment benefits in order to boost demand.
If the economy is growing too fast the government may try to reduce spending to decrease demand and regulate inflation.
How does the fiscal policy affect government spending?
Fiscal policy is the decisions made about government spending and taxes and will depend on government priorities.
Governments vary spending from year to year, and the is set out in their budget.
How does age distribution of the population affect government spending?
An ageing population leads to increased government expenditure on *pensions, social care, healthcare, etc.
A younger population may lead to increased spending on education, community development, etc.
What is net trade? (X-M)
This is the total exports - total imports.
This will be a negative figure if imports and higher than exports.
A deficit value in the UK.
Makes up around 5% of AD.
How does real income affect net trade?
When income is high, people demand more goods. Since the UK cannot always meet this demand, imports increase.
However, high income may also be because businesses are producing and selling more goods to other countries, increasing exports.
How do exchange rates affect net trade?
A strong pound means imports are cheaper and exports are more expensive to foreign buyers.
This increases imports and decreases exports - overall decrease in net trade.
The elasticity of imports and exports will impact their value, affecting the demand for those goods.
How does the elasticity of goods affect net trade?
If prices of UK exports drop - and the goods are elastic - demand for them will increase by a lot, raising their value. Vice versa.
If imports / exports are inelastic, demand won’t change much, even if prices change.
How does the state of the world economy affect net trade?
Depends on the UK’s main trade countries.
If their main export country is doing well, UK exports will increase, also increasing net trade.
The same applies for the other way round.
How does the degree of protectionism affect net trade?
This is an attempt to protect domestic producers from suffering foreign competition.
When protectionism is high in other countries, it’s harder and more expensive for UK businesses to sell goods abroad - exports decrease, so net trade falls.
If protectionism is high in the UK, local businesses are benefitted by reducing competition, reducing UK imports and improving net trade.
However long term, this may lead to retaliation from other countries, affect long-term exports.
How do non-price factors affect net trade?
The factors can be things such as quality, design, and marketing.
When UK good are of higher quality and design, exports will increase. Imports will decrease because locals will buy British goods over foreign goods, increasing net trade.
Well marketed UK goods will also encourage purchase, affecting net trade in the same way.
How do prices affect net trade?
When UK goods’ prices are high, they are less competitive compared to foreign goods, increasing imports.
If the UK inflation rate is higher than in other countries, prices will rise faster.
Changes in prices may be due to productivity, as higher productivity can reduce costs and therefore may lead to lower prices.
The impact this has on the value of imports/exports depends on PED.
Higher prices on exports —> foreign consumers will buy less —> decreases UK exports —> reduced net trade.
