2.2 Aggregate Demand Flashcards
What is aggregate demand
Aggregate demand is the total level of spending in the economy at any given price
What are the components of AD
Consumption
Investment
Government spending
Net exports
what is consumption (AD)
consumer spending on goods and services; it makes up about 60%
of AD, so is the biggest part.
what is investment (AD)
spending by businesses on capital goods, such as new equipment
and buildings as well as working capital e.g. stocks and work in progress; it makes up
about 15-20% of AD. Most investment is by the private sector (about 75%) but there
is also investment by the government.
what is government spending (AD)
spending by the government on providing goods and
services, generally public and merit goods, both on wages and salaries of public
sector workers and on investment goods like new roads and schools. This will
change year on year as governments decides how much they spend.
what is net exports (AD)
exports minus imports: when imports are higher than exports this is a
minus figure as more money leaves the UK than comes in. The UK has a large trade
deficit, but this minor figure and is the least significant part of AD at around 5%.
what is the AD curve
The AD curve is the same as the demand curve for an individual market, but instead of
showing the relationship between price and output, it shows the relationship between price
level and real GDP. Like the demand curve, the AD curve is downward sloping
what is the income effect
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.
what is the substitution effect
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.
what is the real balance effect
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.
what is the interest rate effect
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
what causes a shift in the AD curve
caued by a change in any other variable.
what causes a movement along the AD curve
caused by changing prices
what is consumption
Consumption is spending on consumer goods and services over a period of time.
what is disposable income
Disposable income (Y) is the money consumers have left to spend , after taxes have been
taken away and any state benefits have been added. This means that disposable income is
affected by government taxation as well as wages.
It is the most important factor in determining the level of consumption
what is MPC
the proportion of income that people are likely to spend. For most people, their MPC will be positive but less than 1
poorer people will have a higher MPC as they need to spend a higher proportion of their income to survive.
MPC calculation
Change in consumption /
change in income
what is APC
The average propensity to consume (APC) is the average amount spent on
consumption out of total income. In an industrialised country, the APC for the
economy is likely to be less than one as people save some of their earnings.
APC calculation
total consumption /
total income
what is savings
Savings is what is not spent out of income. An increase in consumption decreases
savings so the same factors which affect consumption are those which affect
savings- but in the opposite way. For example, a rise in confidence will decrease
savings
what is MPS
The marginal propensity to save (MPS) is how much of an increase in income is
saved
MPS calculation
change in savings /
change in income
what is APS
the average propensity to save (APS) is the average amount saved out
of income.
APS calculation
total savings /
total income
how does interest rates effect consumer spending
Most major expenditures are bought on credit so therefore the
interest rate will affect the cost of the good for consumers. If interest rates are high,
the price of the good will effectively be higher since more interest needs to be paid
back and this will lead to a reduction in consumption. High interest rates also
increase mortgage repayments so reduce consumption. Also, a rise in interest rates
decreases the value of shares and so people experience a negative wealth effect.
how does consumer confidence effect consumer spending
One major factor that affects people’s spending is what
they think will happen in the future. If people are confident about the future and
expect pay rises, then they will continue or increase their spending. If they expect
high levels of inflation in the future, they will buy now as it will be at a cheaper price,
so consumption will increase. If they expect a recession and fear possible
unemployment, consumption will decrease as people may save more
how does wealth effects effect consumer spending
Wealth is a stock of assets. People with greater wealth tend to
have greater levels of consumption, known as the wealth effect: a change in
consumption following a change in wealth. The wealth effect is experienced when
real house prices rise as owners now have more wealth so are more confident with
spending as they know that if they go into financial difficulty they could simply borrow
more against the house
how does distribution of income effect consumer spending
Those on high incomes tend to save a higher percentage
of their income than those on low incomes and so a change in the distribution of
money in the economy will affect the level of consumption. If money is moved from
the rich to the poor, consumption is likely to increase as the poor have a higher MPC.
how does tastes and attitudes effect consumer spending
In our modern society, there is a strong materialistic drive
that encourages people to have the newest and the best and therefore spending can
be very high, in some cases even above income. If people were less materialistic,
consumption would decrease.
what is investment
Investment is the addition of capital stock to the economy i.e. machines and factories
used to produce other goods and services. It is only seen as investment if real products are
created so buying a share in a company would be saving but buying new machinery is
investment.
what is gross investment
Gross investment is the amount of investment carried out and ignores the level of depreciation
what is net investment
net investment is gross investment minus the value of depreciation.
how does the rate of economic growth effect economic investment
In a growing economy, there will be higher levels of investment as businesses would be more confident about their investments and the
higher demand would lead to a higher return rate on the investment.
On top of this, a growing economy needs more investment in
order to cope with the higher levels of demand.
what is the accelarator theory
When demand for goods and services increases, companies realize they need to produce more to meet that demand.
To produce more, they often need to invest in new machinery, factories, or technology.
This increase in investment is often greater than the initial increase in demand, leading to a multiplied effect on the economy.
how does business expectations and confidence (animal spirits) effect investment
When businesses
are confident about the future and expect future growth, investment will increase as
they want to prepare for the future. If they are fearful of the future, then they will not
invest money in new ideas or machinery.
how does demand for exports influcence investment
If the world economy is booming, demand for exports is
likely to increase and therefore exporting firms’ investment is likely to increase to
cope with this extra demand. This will have a knock-on effect and encourage other
firms to increase their investment.
how does interest rates influence investment
Most investment is done through borrowing. High interest rates
mean that borrowing is more expensive, so a business needs to be more confident of
good profits in order to cover the extra costs of borrowing. Other investment is done
through retained profits or savings. A rise in interest rates increases the opportunity
cost of a business using retained profits as they are able to get higher interest
payments than before
other factors that influence investment
influence of government and regulations
access to credit
retained profit
technological change
costs
what is government spending
The government has a very significant part to play in the level of AD, through spending. They
spend money on defence, education, the NHS etc.
the trade cycle influence on government expenditure
Decisions over government expenditure may be made in order to manage AD, and therefore regulate 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
fiscal policy influence on government expenditure
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
age distribution of the population influence on government spending
An ageing population leads to increased
government expenditure on pensions, social care etc. whilst a young population
leads to increased spending on education
what is net trade
Net trade is the total exports minus the
total imports.
real income influence on net trade
When real income in the UK is high, there tends to be increased imports as people demand more goods and services and the UK is unable to meet their needs. This will mean that net trade decreases. However, if an increase in real income is due to export-led growth then net trade will increase. Therefore, the effect
of changes in real incomes is dependent on many factors
strong poind influence on net trade.
A strong pound makes imports cheap and exports dear 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. dependent on elasticity.
state of the world economy influence on net trade.
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. The effect of the state of the world economy is dependent on which countries are doing well and the trade relationship the UK has with them.
protectionist levels influence on net trade
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. If the UK imposes protectionist measures, other countries are likely to retaliate and therefore exports are likely to decrease
