2.2 Aggregate Demand (AD)

Question 1

aggregate demand

Answer 1

• the total demand for all goods and services in the economy
• if AD increases, then economic growth has occurred and vice versa

Question 2

components of AD

Answer 2

• AD = C + I + G + (X-M)
• consumption; consumer spending on goods and services; accounts for around 60% of AD
• investment; business spending on capital goods; accounts for approx 15% of AD
• govt. spending; how much govt. spends on state goods and services; accounts for approx 25% of AD
• exports-imports; value of the current account on the BoP, so a positive value = surplus and negative = deficit; most insignificant part of AD

Question 3

AD curve

Answer 3

• diagram 1
• shows the relationship between average price level and total output
• downward sloping due to;
• interest rate effect; as GPL increases, IR are likely to rise too, which reduces investment and incentivises households to save
• wealth effect; as GPL increases, purchasing power of households decrease and AD falls
• exchange rate effect; as GPL falls, IR are likely to fall too, which lowers the ER so the economy’s goods / services are more attractive abroad and exports increase, which increases real GDP

Question 4

movements along AD curve

Answer 4

• diagram 1
• a movement along the curve is caused by a change in GPL in an economy
• fall in price causes an expansion in demand and rise in price causes a contraction

Question 5

shifts of the AD curve

Answer 5

• diagram 2
• caused by changes in the components of AD
• right shift represents economic growth when any components of AD increase

Question 6

influence of disposable income on consumer spenfing

Answer 6

• disposable income; the money that consumers have left after taxes have been paid and any benefits / transfer payments have been recieved
• if taxes increase, wages or transfer payments decrease, then disposable income decreases
• consumption increases as disposable income rises and vice versa

Question 7

relationship between savings and consumption

Answer 7

• when savings decrease, consumption usually increases and vice versa
• household savings ratio calculates household savings as a proportion of household income; the % is often low during a boom and vice versa
• i.e. during lockdown 2020, the ratio reached a record high of 25% in the UK

Question 8

other influences on consumer spending

Answer 8

• interest rates; lower IR makes it cheaper to borrow and reduces incentive to save, so spending increases and also lowers cost of debt so increases disposable income of households, but there are time lags between change in IR and rise in consumption
• higher consumer confidence means they’re less concerned about saving for future difficulties so consumption rises and saving falls
• if consumer wealth increases, e.g. if house prices rise consumers experience a rise in equity, then consumption usually increases

Question 9

gross and net investment

Answer 9

• gross investment; the amount a firm invests in business assets, without accounting for depreciation (loss of value)
• net investment; the actual addition to the capital stock of an economy after depreciations have been considered, i.e. calculated by gross investment - depreciation
• if depreciation in the value of capital is greater than growth in gross investment, there’s a decrease in value of capital and no economic growth

Question 10

influences on investment

Answer 10

• rate of economic growth; high growth means higher rates of consumer spending, so means firms make more profits which can be used to invest
• business expectations and confidence; if firms expect a high rate of return, they’ll invest more
• Keynes and ‘animal spirits’; naive optimism where firms are encouraged by a growing market and take too many risks, including more investment
• demand for exports; higher demand will increase investment as firms aim to meet global demand
• interest rates; lower IR increases investment as the cost of borrowing is less and there’s less incentive to save
• access to credit; the harder access to loans, the lower levels of investment, e.g. after the GFC when banks became risk averse
• influence of govt. and regulations; lower corporation tax, govt. subsidies or tax breaks can encourage investment and high levels of regulation would discourage it

Question 11

the trade cycle and govt. expenditure

Answer 11

• diagram 3
• unemployment decreases with a booming economy, leading to lower levels of benefit payments and vice versa
• tax revenue rises with a booming economy and can be used to repay govt. debt or increase expenditure on public / merit goods and vice versa

Question 12

fiscal policy and govt. expenditure

Answer 12

• fiscal policy involves changing govt. spending and taxation
• during periods of economic decline, the govt. may use expansionary fiscal policy to increase spending on transfer payments or on boosting AD or by reducing taxes
• during periods of economic growth, the govt. may use contractionary fiscal policy by decreasing expenditure on purchases and transfer payments, which reduces the size pf the govt. budget deficit
• automatic stabilisers are fiscal policies which are triggered without govt. intervention, e.g. corporation tax payments will rise during a boom

Question 13

influences on the net trade balance

Answer 13

• net trade = exports-imports (value of the current account on BoP)
• real income; higher income means consumers can afford to consume thus import more, so there’s a larger deficit on current account
• exchange rates; depreciation of £ means imports more expensive and exports are cheaper, so trade deficit narrows (SPICED)
• state of the world economy; world economy boom means increased demand for UK exports and vice versa, e.g. slowdown in Eurozone from 2012-14 caused UK exports to fall
• degree of protectionism; several measures will reduce trade deficit as UK will import less due to tariffs and quotas on imports
• non-price factors; competitiveness of a country’s goods / services, trade deals and trading blocs can impact their exports