2.2 Aggregate Demand

Question 1

What is aggregate demand

Answer 1

Aggregate demand is the total level of spending in the economy at any given price

Question 2

What are the components of AD

Answer 2

Consumption
Investment
Government spending
Net exports

Question 3

what is consumption (AD)

Answer 3

consumer spending on goods and services; it makes up about 60%
of AD, so is the biggest part.

Question 4

what is investment (AD)

Answer 4

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.

Question 5

what is government spending (AD)

Answer 5

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.

Question 6

what is net exports (AD)

Answer 6

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%.

Question 7

what is the AD curve

Answer 7

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

Question 8

what is the income effect

Answer 8

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.

Question 9

what is the substitution effect

Answer 9

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.

Question 10

what is the real balance effect

Answer 10

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.

Question 11

what is the interest rate effect

Answer 11

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

Question 12

what causes a shift in the AD curve

Answer 12

caued by a change in any other variable.

Question 13

what causes a movement along the AD curve

Answer 13

caused by changing prices

Question 14

what is consumption

Answer 14

Consumption is spending on consumer goods and services over a period of time.

Question 15

what is disposable income

Answer 15

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

Question 16

what is MPC

Answer 16

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.

Question 17

MPC calculation

Answer 17

change in income

Question 18

what is APC

Answer 18

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.

Question 19

APC calculation

Answer 19

total income

Question 20

what is savings

Answer 20

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

Question 21

what is MPS

Answer 21

The marginal propensity to save (MPS) is how much of an increase in income is
saved

Question 22

MPS calculation

Answer 22

change in income

Question 23

what is APS

Answer 23

the average propensity to save (APS) is the average amount saved out
of income.

Question 24

APS calculation

Answer 24

total income

Question 25

how does interest rates effect consumer spending

Answer 25

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.

Question 26

how does consumer confidence effect consumer spending

Answer 26

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

Question 27

how does wealth effects effect consumer spending

Answer 27

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

Question 28

how does distribution of income effect consumer spending

Answer 28

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.

Question 29

how does tastes and attitudes effect consumer spending

Answer 29

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.

Question 30

what is investment

Answer 30

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.

Question 31

what is gross investment

Answer 31

Gross investment is the amount of investment carried out and ignores the level of depreciation

Question 32

what is net investment

Answer 32

net investment is gross investment minus the value of depreciation.

Question 33

how does the rate of economic growth effect economic investment

Answer 33

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.

Question 34

what is the accelarator theory

Answer 34

the investment over a period of time is the change in real income times the capital-output ration. the capital output ratio is the amouint of investment needed to produce a givern amount of goods. this, if income rises, the level of investment will rise

Question 35

how does business expectations and confidence (animal spirits) effect investment

Answer 35

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.

Question 36

how does demand for exports influcence investment

Answer 36

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.

Question 37

how does interest rates influence investment

Answer 37

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

Question 38

other factors that influence investment

Answer 38

influence of government and regulations
access to credit
retained profit
technological change
costs

Question 39

what is government spending

Answer 39

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.

Question 40

the trade cycle influence on government expenditure

Answer 40

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

Question 41

fiscal policy influence on government expenditure

Answer 41

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

Question 42

age distribution of the population influence on government spending

Answer 42

An ageing population leads to increased
government expenditure on pensions, social care etc. whilst a young population
leads to increased spending on education

Question 43

what is net trade

Answer 43

Net trade is the total exports minus the
total imports.

Question 44

real income influence on net trade

Answer 44

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

Question 45

strong poind influence on net trade.

Answer 45

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.

Question 46

state of the world economy influence on net trade.

Answer 46

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.

Question 47

protectionist levels influence on net trade

Answer 47

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