[2.2] Aggregate Demand (AD)

Question 1

How is aggregate demand calculated?

Answer 1

C + I + G + (X - M)

C= Consumer Spending
I = Capital Investment
G = Government Spending

(X - M) = Exports - Imports

Question 2

What is the largest component of aggregate demand?

Answer 2

Consumer spending makes up the largest proportion of aggregate demand.

Question 3

What is the second largest component of aggregate demand?

Answer 3

Net exports (X - M)

Question 4

What is the third largest component of aggregate demand?

Answer 4

Government pending

Question 5

What is the smallest component of aggregate demand?

Answer 5

Capital investment

Question 6

Why is the aggregate demand curve downward sloping?

Answer 6

1. As prices go down, consumers will have more disposable income and will thus to be able to spend more products.
2. If prices are lower, exports will be more competitive and thus exports will increase and therefore the value of (X - M) will be greater.

Question 7

How does disposable income impact consumer spending?

Answer 7

As disposable incomes increase, so does consumer spending.

This is because people have more money to spend.

Question 8

What is the relationship between savings and consumption?

Answer 8

As savings increase, consumption decreases.

This is because consumers will be saving rather than spending their income.

Question 9

How do interest rates impact consumer spending?

Answer 9

If interest rates are high, consumner spending will decrease as saving will be more attractive and the cost of borrowing will be higher.

If interest rates are low, consumer spending will be higher as the incentive to save is lower.

Question 10

What is the ‘wealth’ effect?

Answer 10

A rise in the general price levels means assets such as housing will be more expensive.

Since most people in the UK own houses, this makes people ‘feel’ wealthier and thus they will increase their spending.

Question 11

What is the difference between a gross and net investment?

Answer 11

A gross investment is the total amount of money invested into a business (an example of an investment would be purchasing new machinery).

A net investment is the amount of money invested into a business with depreciations subtracted. A depreciation is when something starts to lose value.

Question 12

How does economic growth impact the rate of investment (I)?

Answer 12

If the economy is growing, consumer spending will increase and thus firms will have be making more revenue and more profits. These profits can be reinvested.

Question 13

How do business expectations and business confidence impact the rate of investment (I)?

Answer 13

• If firms expect to make large profits in the future, they will likely increase their investments.
• An upcoming change in government or potential rise in asset prices may cause businesses to slow down investment.

Question 14

What did Keynes mean by ‘animal spirits’?

Answer 14

These are the emotions and instincts of firms and consumers that will impact investments.

If firms ‘feel’ a slowdown in future profits, they will cut current levels of investment.

Question 15

How does demand for exports impact the rate of investment (I)?

Answer 15

A rise in demand for exports will mean greater demand for firms’ products, and thus higher revenues can be expected in the future.

As a result, firms will increase investment.

Question 16

How do interest rates impact the rate of investment (I)?

Answer 16

Investment increases as interest rates fall as the cost of borrowing falls.

However, if interest rates rise, it will become more costly to borrow and there will be a greater incentive to save.

Question 17

How does access to credit impact the rate of investment(I)?

Answer 17

There will be less investment when access to credit is hindered, such as after a financial crisis when banks are unwilling to lend.

This is also dependent on the overall level of consumer saving in the economy, as greater consumer saving means banks will have more money to lend to firms.

Question 18

How do government and regulation impact the rate of investment (I)?

Answer 18

If corporation tax and business rates are lower, firms will have more money available to invest.

Question 19

How does the trade cycle impact government spending?

Answer 19

During periods of economic growth, the government will receive more tax revenue and will be able to spend more.

During recessions, governments may increase spending in order to stimulate the economy.

Conversely, the government may try to decrease spending during periods of economic growth as the economy does not need stimulating.

Question 20

What is fiscal policy?

Answer 20

Changes in government spending and taxation that will impact Aggregate Demand.

Question 21

What is a discretionary fiscal policy?

Answer 21

One-off policy changes that are done in response to changing market conditions.

Question 22

What are automatic stabilisers?

Answer 22

These are policies that are always in place that help ease fluctuations in the economy.

Examples include corporate tax, welfare payments, and unemployment benefit.

Question 23

What is an expansionary fiscal policy?

Answer 23

An expansionary fiscal policy is one that involves an increase in government spending and therefore an increase in aggregate demand.

It may also involve reductions in taxes.

Question 24

What is a contractionary fiscal policy?

Answer 24

A contractionary fiscal policy involves cuts in government spending and tax rises. This has the effect of reducing AD, but will also reduce any government budget deficit.

Question 25

How do real incomes impact net exports?

Answer 25

If consumers’ incomes rise, they will have more money to spend on foreign imports. As a result, our net exports decreases.

Question 26

What do exchange rates impact net exports?

Answer 26

If the value of the pound relative to other currencies decreases (depreciates), there will be an increase in net exports as it will become more expensive to import and UK exports will be more competitive.

The impact of exchange rate changes depends on the currencies. For example, a change in the exchange rate with the U.S. dollar will have a greater impact as they are a major trading partner of the UK.

There must be price elasticity of demand for UK goods, or exports will not increase significantly and their value will decrease.

Question 27

How does the state of the world economy impact net exports?

Answer 27

• If there is a recession in one of our trading partners, demand for our exports will decrease as incomes in those countries will fall.

Question 28

How does the degree of protectionism impact net exports?

Answer 28

• If the UK imposes protectionist policies such as tariffs, we will import less and our net exports will increase.
• However, other countries may retaliate with their own tariffs which will reduce the UK’s net exports.

Question 29

How do non-price-factors impact net exports?

Answer 29

• Trade deals and trading blocs will impact net exports.
• The competiveness of an economy will impact its net exports. Competitiveness can be achieved by having lower labour costs, greater efficiency and higher quality goods.