2.3/2.4 Aggregate Demand And The Level Of Economic Activity Flashcards
Aggregate demand definition
The total planned spending on real output produced within the economy
Aggregate demand equation
C + I + G + (X-M)
Why is aggregate demand and aggregate supply more useful than circular flow of income model?
It’s possible to see the potential inflationary and deflationary impact of changes in government policy, as well as the effect on national income
Why does the aggregate demand curve downward slope from left to right?
- At a lower price level any asset of shares will increase in real terms. Leading to wealth effect and greater consumption.
- at a lower price level UK exports will be more price competitive leading to higher exports
Wealth effect definition
Increase in the value of the household assets cause people to fill wealthier and encourage them to spend more of their current income
Wealth definition
The value of the assets held by households
How much power does consumption have in the AD curve?
It holds 70% of overall AD
What will cause a shift in AD?
Any change in the components of aggregate demand equation
Interest rate definition
The cost of borrowing money expressed as a percentage of the amount borrowed
What are the five things that cause consumption to change?
- interest rates
- consumer confidence
- taxation
- wealth
- unemployment
How do interest rates affect consumption?
- if interest rates rise people with variable-rate mortgages will find that their monthly payments increase = less disposable income = less C
- higher interest rate reduces the desire for households to engage in credit financed consumption (borrowing)
- High interest rates increase the reward for saving which reduces consumption
How does taxation affect consumption?
Changes in taxation will affect how much households have to spend = how much they consume
How does wealth affect consumption?
If households feel wealthier, the wealth effect will occur which equals more consumption
How does unemployment effect consumption?
If more people are unemployed and relying on welfare benefits, then the level of consumption is likely to be lower
What are the five things that affect investment?
- interest rates
- business confidence
- tax
- technology
- accelerator theory
How does interest rates affect investment?
- Increasing interest rates will raise the cost of borrowing and will reduce the profitability of any investment
- even if investment is not finance by borrowing higher interest rates will raise opportunity cost of using money from investment purposes
How does business confidence affect investment?
If businesses expect the sales to increase in the future they will be more likely to invest, vice versa
How does tax effect investment?
Companies are taxed on their profits, corporation tax, if this is lowered this will lead to higher investment
How does technology affect investment?
Newer and more efficient technology leads to more investment, leading to an increase in firms profitability due to higher rates of efficiency
How does the accelerator theory affect investment?
If growth in national income increases, then firms will need a larger productive capacity in order to produce a higher level of output to meet the higher level of spending in the economy which means they must invest
Accelerator theory definition
Where increases in national income lead to firms spending more on investment, in order to expand their capacity to exploit the rising income
Capital stock definition
The value of the existing level of investment products in an economy at a point in time
Budget balance definition
The difference between government spending and the taxation revenue collected The difference between government spending and the taxation revenue collected
Balanced budget definition
Government expenditure is equal to taxation
What affects exports and imports?
- exchange rates
- uk growth
- relative inflation
Exchange rate definition
The price of one currency expressed in terms of another currency
Multiplier affect definition
Initial injection into the economy causes a bigger final increase in national income
How does the multiplier affect work?
Any extra spending, injections, creates income for another person or business. This extra income will intern be spent again, that’s creating income elsewhere for another group, and so on.
Size of multiplier equation
Change in national income
————————————
Initial change in AD
What is a negative multiplier effect
If the government cut spending, this can lead to a spiral of negative outcomes eg. Loss of jobs, etc
Marginal prosperity to consume definition
Refers to the proportion of any additional income that is spent and passed on around the circular flow of income
What will MPC be between?
0 and 1
1 = all additional income is spent
0.5 = half of all additional income is spent
0 = no additional income is spent
Size of multiplier equation using MPC
1
—————
1 - MPC
Size of multiplier using marginal propensity to withdraw
1 1
——— = ————————
MPW MPS+MPT+MPM
Marginal prosperity to save
Marginal prosperity to tax
Marginal prosperity to import
What is crowding out?
- monetarists argue the fiscal multiplier will be limited with the crowding out effect
- if the gov increase AD by more spending or less tax this increases consumption
- however rise is borrowing leaded to a decline in private sector investment
- therefore there is no overall increase in AD
What is the Keynesian view on crowding out?
- in a recession, Keynesians argue that the private sector typically had a glut of non-productive savings, therefore the crowding out affect is limited and there will be a positive multiplier affect
