2.2.1 Characteristics of Aggregate Demand (Edexcel)

Question 1

What is Aggregate Demand?

Answer 1

Total level of planned real expenditure on goods and services produced within a country
in a given time period

Question 2

What are the components of AD?

Answer 2

• Household spending on goods and services i.e. consumption (C)
• Gross Fixed Capital Investment Spending and the Value of the Change in Stocks (I)
• Government Spending on Public Services (G)
• Exports of Goods and Services (X)
• (minus) Imports of Goods and Services (M)

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

Question 3

What is Consumption (C)?

Answer 3

This is the spending by households on goods and services. It is influenced by factors like income, interest rates, and consumer confidence.
Example: During a recession, households may reduce their consumption due to uncertainty about the future, leading to a decrease in C.

Question 4

What is Investment (I)?

Answer 4

Investment refers to spending by businesses on capital goods, such as machinery, buildings, and technology. It is influenced by interest rates, business expectations, and government policies.
Example: Lower interest rates may encourage businesses to invest in new equipment and expand production.

Question 5

What is Government Spending (G)?

Answer 5

This represents government expenditure on public goods and services, such as education, defense, and infrastructure.
Example: A government may increase G by investing in a new highway project to stimulate economic activity and job creation.

Question 6

What is Net Exports (X - M)?

Answer 6

This accounts for the difference between a country’s exports (X) and imports (M). A positive value indicates a trade surplus, while a negative value indicates a trade deficit.
Example: China’s high level of exports relative to imports has contributed to its significant trade surplus.

Question 7

What is the relative importance of consumption (C)?

Answer 7

In many economies, consumption is the largest component of AD. It tends to be stable and less volatile than other components.

Question 8

What is the relative importance of Investment (I)?

Answer 8

Investment can be highly volatile, especially during economic downturns when businesses may delay or reduce capital expenditures.

Question 9

What is the relative importance of Government Spending (G)?

Answer 9

Government spending can be used as a policy tool to stabilize the economy during recessions and boost AD.

Question 10

What is the relative importance of Net Exports (X - M)?

Answer 10

In open economies, the balance of trade can significantly impact AD. Countries with trade surpluses (X > M) contribute positively to AD, while those with trade deficits (X < M) detract from AD.

Question 11

What does the AD curve show?

Answer 11

The Aggregate Demand curve shows the relationship between the overall price level (P) in the economy and the quantity of Real GDP demanded (Y). It typically slopes downward, indicating that as prices rise (inflation), the quantity of Real GDP demanded falls, and vice versa.

Question 12

What does the movement along the AD curve mean?

Answer 12

This occurs when there is a change in the price level (P) while other factors affecting AD remain constant. A change in P leads to a change in the quantity of Real GDP demanded, but the AD curve itself does not shift.
Example: If prices rise (inflation increases), there will be a decrease in Real GDP demanded, resulting in a movement up the AD curve.

Question 13

What does the shift of the AD curve mean?

Answer 13

This occurs when factors other than the price level change, leading to a shift in the entire AD curve. These factors include changes in consumer spending, business investment, government spending, or net exports.
Example: If the government increases its spending on infrastructure projects, it will shift the AD curve to the right, leading to higher Real GDP and potential inflation.

Question 14

What happens when you move along the AD curve?

Answer 14

Question 15

Why does the AD curve slope downwards?

Answer 15

• Real income effect
• Balance of trade effect
• Interest rate effect

Question 16

Explain the real income effect

Answer 16

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 (note – the
change in income is due to the change in the price level)

Question 17

Explain balance of trade effect

Answer 17

A fall in the relative price of level of Country X could make foreign-produced goods and services
more expensive, causing a rise in exports and a fall in imports – the trade balance will improve simply
as a result of a change in the price level

Question 18

Explain interest rate effect

Answer 18

If price inflation is low and this leads to a reduction in interest rates, there is less incentive to save and
a fall in interest rates may also cause the exchange rate to depreciate and improve export sales

Question 19

What happens when the AD curve shifts?

Answer 19

Question 20

What happens when there is a fall in AD?

Answer 20

Question 21

What happens when there is an increase in AD?

Answer 21

Question 22

Many unexpected events cause changes in demand, output and employment. These are called external “shocks”. Name examples of these external shocks.

Answer 22

1. A large rise or fall in the value of the exchange rate
2. A recession, slowdown or boom in a nation’s key trading partner countries
3. A slump in the housing market / construction sector of a country
4. An event such as the Global Financial Crisis which caused a steep fall in the supply of credit available to
   businesses and households
5. A large change in commodity prices for a country that is a commodity exporter