2.2.1 The characteristics of AD

Question 1

Aggregate Demand ( AD )

Answer 1

total planned real expenditure on a country’s goods and services produced within an economy in each time period

Question 2

Components of AD

Answer 2

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

Question 3

Consumption

Answer 3

the total spending on goods / services by consumers households in an economy

Question 4

Investment

Answer 4

the total spending on capital goods by firms ( gross fixed capital investment spending + the value of the change in stocks )

Question 5

Government spending

Answer 5

the total spending by the government in the economy : Includes public sector salaries , payments for provision of merit and public goods etc. It does not include transfer payments

Question 6

Net exports

Answer 6

the difference between the revenue gained from selling goods / services abroad and the expenditure on goods services from abroad. Individuals , firms and governments export / import.

Question 7

The % that each component contributes to AD in the UK

Answer 7

Consumption : 60 %
Investment : 14 %
Government spending : 25 %
Net Exports : 1 %

Question 8

Why is the AD curve downward sloping?

Answer 8

The AD curve is downward sloping so as average price level decreases , AD increases .

1. The interest rate effect : At lower average price ( AP ) levels , there are likely to be lower interest rates . Lower interest rates increase investment and are an incentive for households to spend . Consumption increases so AD increases .
2. The wealth effect : As AP falls , the purchasing power of households increases and the AD rises . Consumption increases so AD increases
3. The exchange rate effect : As AP falls , interest rates are likely to fall too . Lower interest rates lower the exchange rate . With a lower exchange rate , the economy’s goods / services are more attractive abroad and exports increase , thereby increasing real GDP . Net exports increase so AD increases

Question 9

What is the difference between movement along the AD curve and shifts of the AD curve?

Answer 9

Whenever there is a change in any of the components of aggregate demand ( AD ) in an economy , there is a shift of the entire AD curve. Whenever there is a change in the average price level ( AP ) in an economy , there is a movement along demand ( AD ) curve . A change in price level is caused by inflation or deflation .

Question 10

Causes of shifts in the AD curve

Answer 10

1. Changes in real incomes and employment C
2. Changes in government spending , taxation and borrowing C + G
3. Changes in monetary policy interest rates and the supply of credit C + I
4. Changes in the external value of a country’s exchange rate ( X - M )
5. Changes in the rate of economic growth of trading partner nations ( X - M )
6. Fluctuations in consumer and business confidence C + I

Question 11

What is the difference between rates of change and absolute change?

Answer 11

It is important to distinguish between rates of change and absolute change : a fall in the amount of consumption will reduce AD but a fall in the rate of rise of consumption means that consumption is still rising so AD will still increase but by not as much .

Question 12

Do any factors cause both a movement along and shift of the AD curve? If so, any examples?

Answer 12

Some factors , for example interest rates , could cause a movement or a shift in the AD curve . When prices increase , interest rates rise ( because of the interest rate effect ) and this causes a movement along the AD curve but if the government increases the interest rate then there is a shift in the AD curve . It is important to always look at whether the change is because of price or not .