2.2 - Aggregate Demand Flashcards
Aggregate Demand
The total demand for goods and services in an economy at a given price level over a period of time
Formula for Aggregate Demand
AD = C + I + G + (X - M)
Components of Aggregate Demand
- Consumption
- Investment
- Government spending
- Net exports
Axis for an Aggregate Demand curve
- Price level (Y-Axis)
- Real Gross Domestic Product (X-Axis)
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
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 aggregate demand will contract
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 Aggregate Demand
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 Aggregate Demand will contract
Disposable income
The amount of income left for individuals or households after paying taxes and receiving government transfers, available for spending or saving, reflecting the real purchasing power of consumers
Marginal Propensity to Consume
The proportion of an additional unit of income that a consumer is likely to spend on goods and services, rather than saving
Formula for Marginal Propensity to Consume
Change in consumption / Change in income
Average Propensity to Consume
The proportion of total income that is spent on consumption
Formula for Average Propensity to Consume
Total consumption / Total income
Marginal Propensity to Save
The proportion of an additional unit of income that a consumer saves rather than spends
Formula for Marginal Propensity to Save
Change in savings / Change in income
Average Propensity to Save
The proportion of total income that is saved rather than consumed
Formula for Average Propensity to Save
Total savings / Total income
Influences on consumer spending
- Interest rates
- Consumer confidence
- Wealth effects
- Distribution of income
- Tastes and attitudes
Gross investment
The total amount spent on new capital goods, such as machinery, buildings, and equipment, in a given period, without accounting for depreciation
Net investment
The total amount spent on new capital goods, after accounting for depreciation
Formula for net investment
Gross investment - Depreciation
Influences on investment
- Rate of economic growth
- Business expectations and confidence (Animal spirits)
- Demand for exports
- Interest rates
- Influence of government and regulations
- Access to credit
- Technological change
- Costs
Influences on government expenditure
- The trade cycle
- Fiscal policy
- Age distribution of the population
How the trade cycle influences government expenditure
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
How fiscal policy influences government expenditure
Fiscal policy is the decisions about government spending and taxes and it will depend on the priorities of the government. The level of government spending depends on what they lay out in their fiscal policy
How age distribution of the population influences government expenditure
An ageing population leads to increased government expenditure on pensions, social care etc. whilst a young population leads to increased spending on education. The more dependents in the economy (the young and old), the higher government spending tends to be
Net trade
The difference between a country’s exports and imports, so if exports exceed imports there is a trade surplus but if imports exceed exports there is a trade deficit
Formula for net trade
Exports - Imports
Influences on net trade balance
- Real income
- Exchange rates
- State of the world economy
- Degree of protectionism
- Non-price factors
- Prices
How real income influences net trade balance
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
How exchange rates influence net trade balance
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, but this depends on the elasticity of imports and exports
How the state of the world economy influences net trade balance
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
How the degree of protectionism influences net trade balance
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
How non-price factors influence net trade balance
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 the British goods instead of foreign goods, meaning net trade will increase
How prices influence net trade balance
High prices of UK goods will mean that the goods are less competitive compared to international goods since people make decisions partly based on price. This means the volume of exports will decrease and the volume of imports will increase
