2.2.1 Aggregate Demand (AD)

Question 1

Calculation for aggregate demand

Answer 1

Aggregate Demand = Consumption + Investment + Government expenditure + (Exports – Imports)

AD = C + I + G = (X-M)

Question 2

Aggregate Demand (AD)

Answer 2

The total demand in an economy over a given period of time.

Question 3

Components of Aggregate Demand

Answer 3

• Consumption (C) is the total amount spent by households on goods and services.
• Investment (I) is money spent by firms on assets which they’ll use to produce goods or services. This includes machinery, computers and offices.
• Government expenditure (G) is money spent by governments.
• Net trade (X-M) is the balance between exports and imports. (exports – imports).

Question 4

Aggregate Demand Curve

Answer 4

Question 5

What does the price level represent on an AD diagram?

Answer 5

• The average level of prices in an economy.

In the UK this price level is the Consumer Price Index (inflation).

Question 6

Why does the AD curve slope downwards?

Answer 6

The lower the price level, the more output is demanded. Lower prices mean consumers can buy more goods/services with their money.

Question 7

Why will a rise in the price level cause output to fall?

Answer 7

• Domestic consumption will be reduced – things become more expensive, so people can purchase fewer goods and services.
• The demand for exports will be reduced - domestically produced products become less competitive.
• The demand for imports will increase – if prices haven’t risen abroad, imports will become cheaper in comparison.

Question 8

Why will the AD curve shift left?

Answer 8

If there’s a fall in consumption, government expenditure (spending) or net exports that hasn’t been caused by a change in the price level.

For example, as a result of a rise in interest rates, or a stronger currency.

Question 9

AD curve shifting left

Answer 9

The inward shift of the curve means that at a given price level (P), less output (T2) can be produced – but also, a given amount of output (Y) will have a lower price level (P2). There will also be a decrease in employment levels.

Question 10

Why will the AD curve shift right?

Answer 10

If there’s a rise in consumption, government expenditure (spending) or net exports that hasn’t been caused by a change in the price level.

For example, as a result of a reduction in income tax, a weak currency, or a change in the government’s fiscal policy.

Question 11

AD curve shifting right

Answer 11

The outward shift of the curve means that at a given price level, more output can be produced – but also, a given amount of output will have a higher price level. For example, if there’s an increase in aggregate demand from AD to AD1 – at price level P, there’s an increase in output from Y to Y1, and at output Y, the price level increases from P to P1.

Question 12

Marginal propensity to consume (MPC)

Answer 12

The proportion of any extra income that is spent on the consumption of goods and services.

Question 13

Marginal propensity to save (MPS)

Answer 13

The proportion of any extra income that is saved.

Question 14

Formulas for MPS and MPC

Answer 14

Question 15

Formula for calculating the multiplier

Answer 15

Question 16

Marginal Propensity to Tax (MPT)

Answer 16

The proportion of any new income that’s paid as taxes.