2.2 Aggregate Demand LS3

Question 1

Aggregate demand definition?

Answer 1

The total amount of spending on goods or services produced in an economy during a period of time

Question 2

AD formula?

Answer 2

C + I + G + (X-M)
Consumer spending
Investment
Government expenditure
Net exports

Question 3

Wealth definition?

Answer 3

The value of assets that people own, including their houses, stocks and bonds, their jewellery, works of arts

Question 4

Explain the wealth effect on AD

Answer 4

Changes in the price level affect the real value of people’s wealth
* As price levels increase, the real value of wealth decreases
* People feel worse off and cut back on their spending
* Therefore, less output is demanded leading to a contraction along the AD curve

Question 5

Effect of international trade effect on AD curve?

Answer 5

• If domestic prices increase while price levels in other countries stay the same
• Exports become more expensive to foreign buyers so demand for them will decrease and there will be less exports
• Imports become relatively cheaper so domestic buyers will increase their imports from foreign countries
• Results in a fall in net exports (more imports than exports) which means a fall in the quantity of output demanded
• So, contraction along the AD curve

Question 6

The interest-rate effect on AD curve?

Answer 6

• Increased price levels means consumers and firms need more money to carry out their purchases and transactions
• Leads to an increase in demand for money, which leads to increased interest rates
• Increased interest rates means increased cost of borrowing which means decreased consumer purchases (that are financed by borrowing)
• Therefore, leads to a fall in quantity of output demanded and a contraction along the AD curve

Question 7

What causes a movement along the AD curve and what causes a shift of the AD curve?

Answer 7

Movement (contraction/expansion): caused by changes in price levels
Shift (to right or left): caused by changes in individual components of AD (i.e. consumption, investment, government spending, net exports)

Question 8

Reasons for shifts to the left in AD curve

Answer 8

• Fall in net exports
• Cuts in government expenditure
• Increased interest rates and decreased consumer confidence
• Decline in household wealth and therefore decreased consumer confidence

Question 9

Reasons for shift to the right in AD curve

Answer 9

• Depreciation on exchange rate makes exports more competitive
• Cuts in direct/indirect taxes
• Increase in house prices can increase consumer wealth and confidence
• Expansion on supply of credit (greater willingness to lend)
• Decreased interest rates

Question 10

Consumption definition?

Answer 10

The spending on consumer goods and services over a period of time

Question 11

Determinants of consumption and definitions?

Answer 11

• Consumer confidence: A measure of how optimistic consumers are about their future income and the future of the economy
• Changes in interest rates: The cost of borrowing money
• Changes in wealth: The value of assets that people own, including their houses, stocks and bonds, their jewellery, works of arts
• Changes in the level of household indebtedness: How much money people owe from taking out loans in the past

Question 12

How does consumer confidence affect the AD curve?

Answer 12

If consumers are more optimistic about the future or expect their incomes/wealth to rise, theyre more likely to spend more on goods or services, and the AD curve shifts to the right

Low consumer confidence indicates expectations of fallling incomes, worsening economic conditions due to fears of wages cuts and unemployment, causing decreased spending and AD curve shifts to the left

Question 13

How do changes in interest rates affect the AD curve?

Answer 13

Some consumer spending is financed by borrowing so increase in interest rates means increase in cost of borrowing and lower consumer spending and AD curve shifts to the left

A fall in interest rates means a lower cost of borrowing and higher consumer spending and AD curve shifts to the right

Question 14

How do changes in wealth affect AD curve?

Answer 14

Increase in wealth makes people feel wealthier so they spend more and AD curve shifts to the right

Decrease in wealth makes people feel less wealthier so spend less and AD curve shifts to the left

Question 15

How do changes in personal income taxes affect the AD curve?

Answer 15

If government increase personal income taxes, consumers have less disposable income so spending drops and AD curve shifts to the left

If government reduce personal income taxes, disposable income increases so consumers likely to spend more and AD curve shifts to the right

Question 16

How do changes in household indebtedness affect the AD curve?

Answer 16

High level of indebtedness means consumers under pressure to make high monthly payments to pay back loans plus interest so less likely to spend money on goods and services so AD shifts to the left

Low level of indebtedness results in an increase in consumer spending so AD curve shifts to the right

Question 17

Investment definition?

Answer 17

The addition to the capital stock of the economy through spending on capital goods such as factories, machinery and tools

Question 18

Capital stock definition?

Answer 18

The total amount of capital goods in a firm, industry or economy

Question 19

Gross investment vs net investment?

Answer 19

Gross investment measures investment before depreciation whilst net investment is gross investment - the value of depreciation

Question 20

Investment in human capital vs investment in physical capital?

Answer 20

Investment in human capital is investment in the education and training of workers

Investment in physical capital is investment in factories etc. (Physical investment is the investment component in AD)

Question 21

How does the rate of interest affect the level of investment?

Answer 21

Some investment is financed by borrowing so higher interest rates = higher cost of borrowing = less investment

Some investment is financed by retained profit (savings) so high interest rates on savings = more attractive to save instead of invest in physical capital. Low interest rates on savings = less inclined to save = higher investment into capital goods

Question 22

Determinants of investment and impacts on AD?

Answer 22

• Changes in business confidence: if businesses arent optimistic about their future sales/economic activities, they’ll spend less on investment and AD curve shifts to left
• Changes in interest rates:
• Changes in technology: improvements in technoloy stimulate investment, increases AD and AD curve shifts to right
• Changes in business taxes: Increased taxes on profits of businesses means after-tax profits fall therefore investment spending decreases and AD decreases and shifts leftwards
• Level of corporate indebtedness: Like consumer indebtedness, less inclined to spend and make investments so AD shifts to left
• Legal/institutional changes: Many developing/transitioning economies have laws/institutions that dont favour small businesses and they dont have access to credit so they dont have the necessary laws that secure property rights

Question 23

Factors affecting government expenditure?

Answer 23

• Changes in political priorities: may choose to increase/decrease its expenditures in response to choose in its priorities
• Changes in economic priorities: deliberate efforts to influence AD

Question 24

Factors affecting net trade

Answer 24

• Changes in national income abroad: decreases in national incomes abroad can decrease exports
• Changes in exchange rates: if exchange rate increases, imports become cheaper but exports become more expensive so decrease so net exports falls
• Changes in level of trade protection: less trade restrictions = more exports and shift in AD to right