2.2 Aggregate Demand Flashcards
What is Aggregate Demand (AD)?
The total level of spending in the economy at any given price.
AD is composed of consumption, investment, government spending, and net exports.
What is the formula for Aggregate Demand?
AD = C + I + G + (X - M)
Where C = consumption, I = investment, G = government spending, X = exports, and M = imports.
What component of Aggregate Demand makes up about 60%?
Consumption
It refers to consumer spending on goods and services.
What is the role of investment in Aggregate Demand?
It accounts for about 15-20% of AD and includes spending by businesses on capital goods.
Most investment is by the private sector.
What percentage of GDP does government spending typically represent?
Around 18-20%
Government spending includes provision of public and merit goods.
What is net exports in the context of Aggregate Demand?
Exports minus imports, typically accounting for around 5% of AD.
A negative value indicates a trade deficit.
Describe the AD curve.
It shows the relationship between price level and real GDP and is downward sloping.
A rise in prices leads to lower real GDP.
What is the income effect?
As prices rise without an immediate rise in income, real incomes fall, leading to reduced demand.
This contributes to the downward sloping nature of the AD curve.
Define the substitution effect.
If UK prices rise, foreigners buy less British exports, and UK residents buy more imports, decreasing net exports.
This results in a contraction of AD.
What does the real balance effect refer to?
A rise in prices reduces the value of savings, causing people to save more and spend less, leading to a contraction in AD.
This effect highlights how purchasing power influences spending.
Explain the interest rate effect.
Higher prices lead to higher demand for money, causing interest rates to rise, which reduces borrowing and investment, contracting AD.
This illustrates the link between price levels and monetary policy.
What causes a movement along the AD curve?
A change in prices, caused by inflation or deflation.
Movement indicates a change in quantity demanded at a given price level.
What causes a shift in the AD curve?
A change in any other variable, such as consumer confidence or government spending.
A rightward shift indicates an increase in AD, while a leftward shift indicates a decrease.
What is disposable income?
The money consumers have left to spend after taxes and state benefits.
It is a key factor in determining consumption levels.
Define marginal propensity to consume (MPC).
The proportion of additional income that is spent on consumption.
MPC typically is positive but less than 1.
What is average propensity to consume (APC)?
The average amount spent on consumption out of total income.
In industrialized countries, APC is generally less than one.
What is the relationship between savings and consumption?
An increase in consumption decreases savings.
The same factors that affect consumption inversely affect savings.
What is the marginal propensity to save (MPS)?
The proportion of additional income that is saved.
MPS is calculated as change in savings over change in income.
How do interest rates influence consumer spending?
High interest rates increase the cost of credit, leading to reduced consumption.
This includes effects on mortgage repayments and consumer confidence.
What is the wealth effect?
Greater wealth leads to higher levels of consumption, as individuals feel more confident spending.
This is often observed when real estate or share prices rise.
How does the distribution of income affect consumption?
If wealth shifts from rich to poor, consumption is likely to increase due to a higher MPC among poorer individuals.
Changes in income distribution can significantly impact overall consumption levels.
What is investment in economic terms?
The addition of capital stock to the economy, such as machinery and factories.
It is only considered investment if real products are created.
What is the difference between gross and net investment?
Gross investment ignores depreciation, while net investment accounts for it.
In the UK, depreciation can account for about 75% of gross investment.
What influences investment levels?
- Rate of economic growth
- Business expectations and confidence
- Demand for exports
- Interest rates
- Government influence and regulations
- Access to credit
- Retained profits
- Technological change
- Costs
Each factor can significantly alter firms’ willingness to invest.
