2.2 Aggregate Demand Flashcards
What is aggregate demand?
The total planned expenditure on goods and services produced in an economy over a period of time
What is the formula for aggregate demand?
C + I + G + (X-M)
C = Consumption
I = Investment
G = government spending
(X-M) = net exports
Why is the AD curve downwards sloping?
- At lower prices, exports are more competetive internationally, therefore net exports are higher at lower price levels
- Total expenditure remains the same - the real balance effect
- At higher price levels, interest rates are high meaning it is hard to borrow and rewarding to save. This means consumption and investment falls, and savings rise, so AD is smaller.
What are the proportions of each component of AD?
- Consumption - 60%
- Investment - 10-15%
- Goverment spending - 25%
- Net exports - ~1%
What is consumption?
Consumer spending
How does disposable income interact with consumption?
- Disposable income is income after tax
- The higher it is, the more people will spend
What is the relationship between consumption and saving?
- If people save, they will spend less
- Saving therefore reduces consumption
- As people earn more and more, they save marginally more (spend at a slower rate)
Explain three other determinants of consumption
- Interest rates - if they are lower, it is easier to borrow so people can take out mortgages, consumer durable payments, and credit cards. Interest payments go down so disposable income increases. There is also less incentive to save.
- Confidence - if people feel like they need to save for a recession or high unemployment, their confidence is low and their consumption falls.
- Wealth effects - when housing prices rise home owners can extract more equity from property.
What is the difference between gross and net investment?
Gross investment is investment into capital stock before taking into account any depreciation of assets (e.g. redundant and faulty capital)
Net investment is gross investment - depreciation; it takes into account the fall in value of capital assets.
Give 3 examples of influences on investment
- Interest rates - it is harder to finance investment if it is expensive to borrow. Firms closely watch future interst rates to decide when and if to borrow.
- Profit - investment may be limited if profit is limitd too
- Tax - high tax means less invesment funds
- Government policy - increasing goverment spending and reduced taxes means higher consumption, leading to higher profit and investment
- Exchange rate - a low exchange rate means increased export of goods to abroad, therefore increasing possible and current profits.
- Access to credit - is it easy to borrow, conditions
- New technology - incentive to increase productivity and decrease unit costs
- Business confidence - confidence in future consumption, the current market and economy, government regulations means higher investment and risks
What are animal spririts? How do they influence the decisions to invest?
These are the forces that make markets move in large booms and busts, as people buy and sell impuslively rather than calmly and rationally.
This means that in moments of panic, or desperation to make profits and avoid loss, people fellow herd behaviour and make sudden movements.
What are the main influences on goverment expenditure?
- the trade cycle - expenditure falls in a boom and rises in a bust
- fiscal policy - this is the manipulation of spending and tax in order to influence AD
- Government’s also consider the level of national debt, as they want to avoid the cost on future generations
What is net exports?
Exports subtract imports.
Explain five factors that affect net exports
- Change in real incomes - increase in consumption means increase in imports from abroad, which harms net exports
- Change in the exchange rate - if this decreases then exports are more competetive and imports are more expensive. In the short time however, PED of net exports is low (contracts, lack of substitutes)
- Changes in global economy - competetiveness of UK compared to other countries, natural disasters, pandemic
- Degree of protectionism - this affects tarrifs and import taxes, how much are countries trying to protect their own economy (e.g. Trump)
- Non-price factors - quality and after-sales service.
