2.2.1 + 2.2.2 Flashcards
Aggregate Demand
total planned real expenditure on goods and services produced within a country in a given time period.
C+I+G+(X-M)
aggregate demand curve shows a relationship between…
Aggregate Demand and the general price level, and real gdp
Lower GPL =
expansion of AD = higher real GDP
Higher GPL =
Contraction of AD = lower gdp
why the AD Curve Slopes Downwards
- real income effect
- balance of trade effect
- interest rate effect
Real income effect
As the price level falls, the real value of income rises, and consumers are able to buy more of what they want or need
– this is known as the real money balance effect or real income effect
- the change in income is due to the change in the price level
Balance of trade effect
If UK price level rises, less demand from other counties for UK goods, so less goods exported, so net trade decreases and AD contracts
Interest rate effect
High interest rates - more saving - less consumption - inward shift of AD
Causes for fall in AD
- Fall in net exports (M>X)
- cut in real level of gov spending
- higher interest rates/ fall in the supply of credit from banking systems
- decline in household wealth and confidence
Causes for increases in AD
- Depreciation in the value of the exchange rate
- Cuts in the rate of direct and indirect taxes
- Increase in house prices and share prices
- Expansion of supply of credit + lower interest rates
External Shocks and Aggregate Demand
- unexpectedly large rise or fall in the value of exchange rate.
- A recession, slowdown or boom in a nation’s key trading partner countries.
- A slump in the housing market / construction sector of a country heavily reliant on these industries
- An event such as the Global Financial Crisis which caused a steep fall in the supply of credit available to businesses and households and which ultimately led to recession in many countries.
- A large change in commodity prices for a country that is a commodity exporter or a net commodity importer
External shock definition
unexpected economic events cause changes in demand, output and employment
Consumption (C)
Consumption is spending on consumer goods and services
Marginal Propensity to Consume (MPC)
Marginal propensity to consume is the change in spending following a change in income (ΔC/ΔY).
o receives extra pay of £2000 and spend £1500
o MPC is £1500 / £2000 = 0.75
o rest is saved so marginal propensity to save (MPS) is 0.25
Factors that affect consumer spending
- Real Disposable Income
- Employment and Job Security: When labour market is improving, confidence and incomes improve.
- Consumer Confidence: Uncertainty causes spending to fall, improving animal spirits will improve demand.
- Market Interest Rates
Importance of Consumer Confidence
CC surveys measures a range of consumer attitudes, including forward expectations of the economic
situation and households’ own financial positions, and their views on making major purchases such as a new car or home
improvements.
- Keynesian economists refer to this as animal spirits.
Formula for saving in a CLOSED economy
Disposable income (yd) = Consumption + saving
yd = c + s
Disposable income - income after taxes and benefits
Saving ratio
- saving ratio for households measures the amount of money households have available to save as a % of their total yd = the average propensity to save (APS).
• If a person has income of £25,000 and saves £2500 of this, the savings ratio is 10%.
Real interest rate
The nominal interest rate adjusted for inflation.
A positive real interest rate incentivises saving
How Price Expectations affect level of household saving
If consumers expect prices to fall (i.e. deflation) they may choose to save more now
How job security affects household saving
If unemployment rises = job security decreases = more people save more as a precaution
How consumer confidence affects household saving
When consumer confidence is strong, people are more willing to spend/borrow and save less
Importance of saving
- business survival
- funding investment
- buffer of financial resources for consumers
Business survival
- Corporate savings provide a cushion during a recession when sales and revenues are falling.
- Business savings can be used as finance for takeovers and for capital investment projects.
Funding investment
- Commercial banks need savings deposits from which they can lend to borrowers.
- Savings flow into pension funds – these can be reinvested in stock markets providing investment funds.
Buffer of financial resources for consumers
- Savings can smooth consumption during tough economic times.
- They allow people to reduce their debts.
- Savings are a key source of retirement income i.e. they help to smooth consumption over one’s life.
