2.2 - Aggregate Demand Flashcards
What is aggregate demand?
Aggregate demand is the total of all demands (or expenditures), in an economy at any given price level.
What are the four components of AD?
- Consumption (forms 60% of AD and it consists of households consuming goods and services)
- Investment (15% of AD involving a firm’s investment in goods or services)
- Government spending (24% of AD, involving government spending on NHS, infrastructure, new roads)
- Net exports (1% of AD, consists of a nation’s total trade)
Give the formula of aggregate demand.
AD = C + I + G + (X - M)
Aggregate Demand = Consumption + Investment + Government Spending + Net Exports (total exports - total imports)
What is the price level?
Theoretically, the price level is the average level of prices in an economy. Practically, the price level is obtained by the CPI (Consumer Price Index) which measures inflation.
What does the aggregate demand curve show?
The AD curve shows the aggregate demand levels at different price levels.
Give one reason why the AD curve is downwards sloping.
If the average price level rises, this causes inflation hence the purchasing power of money falls and real GDP falls as well. On the x-axis, the real GDP will move to the left while the y-axis price level will go upwards, causing a downward sloping curve.
Give another reason why the AD curve is downwards sloping.
The International Competitiveness Argument - As the average price level increases, the decrease in real national output will make the government focus more on imports than exports, so that the nation can gain economic resources to survive inflation. This will cause a fall in the X component of AD, while the M component will increase but AD as a whole will decrease.
Describe a third factor why the AD curve is downwards sloping.
Interest rates - As the average price level rises, interest rates will rise, causing more interest to be charged. As a result, households tend to save more money and firms will be reluctant to invest in goods and services. Therefore, the I (investment) component of AD will fall which will weaken AD.
What is consumption?
Consumption is the total spending by a household on goods and services to satisfy needs and wants.
Define disposable income.
Disposable income is the income received upon paying direct taxes or transfer payments.
What is the APC?
The APC (Average Propensity to Consume) is the proportion of total income consumed; APC = consumption / total income
What is MPC?
The MPC (Marginal Propensity to Consume) is the proportion of extra income consumed; MPC = change in consumption / change in total income.
Give a factor affecting consumption.
The wealth effect: this is where consumers tend to consume more goods and services when feeling more financially comfortable. When the value of assets of a consumer rise (assets include homes, investments…), the finance of consumers will be strengthened (through rises in share prices) hence they will be more confident and consume more goods/services.
Describe another factor affecting consumption.
Real disposable income; if the disposable income of a consumer continually rises then this will increase affordability for the consumer, which in turn helps with higher consumption of goods and services. However, disposable income can be affected by the financial burden of taxation, eligibility of claiming state benefits or the rate of inflation effect on wages.
Give a third factor affecting consumption.
Change in interest rates: With high interest rates, consumers will have to pay higher outstanding loans therefore consumption will fall while saving will rise (this may affect the savings ratio S/Y). Another reason why consumption may fall is because now interest payments will rise when a consumer needs to take out a loan or mortgage, decreasing demand for houses.
