2.3 The Determinants Of Aggregate Demand

Question 1

What is aggregate demand?

Answer 1

• the total demand in the economy.
• It measures spending on goods and services by consumers, firms, the government and overseas consumers and firms.
• It is made up of the following components, which make up the equation: C + I + G +(X-M)

Question 2

What is consumer spending?

Answer 2

• This is how much consumers spend on goods and services.
• This is the largest component of AD and is therefore most significant to economic growth.
• It makes up just over 60% of GDP.

Question 3

What is disposable income?

Answer 3

• Disposable income is the amount of income consumers have left over after taxes
  and social security charges have been removed.
• It is what consumers can choose to
  spend.
• Consumer income might come from wages, savings, pensions, benefits and
  investments, such as dividend payments.

Question 4

What is a consumers marginal propensity to consume?

Answer 4

• how much a consumer changes their spending following a change in income.

Question 5

What is a consumers marginal propensity to save?

Answer 5

• the proportion of each additional pound of household income that is used for saving.
• A consumer’s marginal propensity to consume added to the marginal propensity to save is equal to 1.

Question 6

What factors influence consumer spending?

Answer 6

• Interest rates
• Consumer confidence

Question 7

Factors influencing consumer spending-interest rates

Answer 7

• If the Monetary Policy Committee lowers interest rates, it is cheaper to
  borrow and reduces the incentive to save, so spending and investment
  increase.
• However, there are time lags between the change in interest rates
  and the rise in AD, so this is not suitable if a rise in AD is needed immediately
• Lower interest rates also lower the cost of debt, such as mortgages.
  -This
  increases the effective disposable income of households.

Question 8

Factors influencing consumer spending-Consumer confidence

Answer 8

• Consumers and firms have higher confidence levels, so they invest and spend
  more, because they feel as though they will get a higher return on them.
  -This is affected by anticipated income and inflation.
• If consumers fear unemployment or higher taxes, consumers may feel less
  confident about the economy, so they are likely to spend less and save more.
  -This delays large purchases, such as houses or cars.

Question 9

What is capital investment?

Answer 9

• This accounts for around 15-20% of GDP in the UK per annum, and about ¾ of this comes from private sector firms.
• The other ¼ is spent by the government on, for example, new schools.
• This is the smallest component of AD

Question 10

What factors influence investment?

Answer 10

• The rate of economic growth
• Business expectations and confidence
• Demand For exports
• Interest rates
• Access to credit
• The influence of government and regulations

Question 11

Factors influencing investment- the rate of economic growth

Answer 11

• If growth is high, firms will be making more revenue due to higher rates of
  consumer spending.
  -This means they have more profits available to invest.

Question 12

Factors influencing investment-business expectations and confidence

Answer 12

• If firms expect a high rate of return, they will invest more.
• Firms need to be certain about the future, otherwise they will postpone their investments.
• Also, expectations about society and politics could affect investment.
• For example, if a change in government might happen, or if commodity prices are due to rise, businesses may postpone their investment decisions.
• Keynes coined the term animal spirits when describing instincts and emotions of human behaviour, which drives the level of confidence in an economy.

Question 13

Factors influencing investment- demand for exports

Answer 13

• This is related to the rate of market demand.
• The higher demand is, the more likely it is that firms will invest.
• This is because they expect higher sales, so they might direct capital goods into the markets where consumer demand is increasing.

Question 14

Factors influencing investment- interest rates

Answer 14

• Investment increases as interest rates falls.
  -This means that the cost of borrowing is less and the return to lending is higher.

-The higher interest rates are, the greater the opportunity cost of not saving
the money.
- high interest rates might make firms expect a fall in consumer spending, which is likely to discourage investment.

Question 15

Factors influencing investment- access to credit

Answer 15

• If banks and lenders are unwilling to lend, such as shortly after the financial
  crisis when banks became more risk averse, firms will find it harder to gain access to credit, so it is either more expensive or not possible to gain the funds for investment.
• Firms could use retained profits, however.
• The availability of funds is dependent on the level of saving in the economy.
  -The more consumers are saving, the more available fund are for lending, and
  therefore for investing.

Question 16

Factors influencing investment-the influence of government and regulations

Answer 16

• The rate of corporation tax could affect investment.
• Lower taxes means firms keep more profits, which could encourage investment.

Question 17

What is the accelerator process?

Answer 17

• The accelerator effect suggests that the level of investment in an economy is
  related to the change in GDP.
• A higher rate of economic growth causes more investment.
• If the rate of economic growth is slowing, but the economy is still growing, the level of investment might fall.
• The level of investment is more volatile than the rate of economic growth.

Question 18

What is government spending?

Answer 18

• This is how much the government spends on state goods and services, such as schools and the NHS.
• It accounts for 18-20% of GDP.
• Government spending is the third largest component of AD.

Question 19

What factors influence government spending?

Answer 19

• the trade cycle/ business cycle
• Fiscal policy

Question 20

Factors influencing government spending-the business cycle

Answer 20

• the business cycle, refers to the stage of economic growth that the economy is in.
• the economy goes through periods of booms and busts.
• Real output increases when there are periods of economic growth.
  -This is the recovery stage.
• The boom is when economic growth is fast, and it could be inflationary or
  unsustainable.
• During recessions, there real output in the economy falls, and there is negative
  economic growth.
• During recessions, governments might increase spending to try and stimulate the economy.
  -This could involve spending on welfare payments to help people who have
  lost their jobs, or cutting taxes.
  -This will increase the government deficit, and they may have to finance this.
• During periods of economic growth, governments may receive more tax revenue
  since consumers will be spending more and earning more.
  -They may decide to spend
  less, since the economy does not need stimulating, and fewer people will be claiming benefits.

Question 21

Factors influencing government spending-fiscal policy

Answer 21

• Governments use fiscal policy to influence the economy.
• It involves changing government spending and taxation.
• Governments might spend on public goods and merit goods, as well as welfare payments.

-Fiscal policy is a demand-side policy, so it works by influencing the level or
composition of AD.

• Discretionary fiscal policy is a policy which is implemented through one-off
  policy changes.
• Automatic stabilisers are policies which offset fluctuations in the economy.
  -These include transfer payments and taxes.
  -They are triggered without government intervention.
• The government might use expansionary fiscal policy during periods of economic decline.
  -This involves increasing spending on transfer payments or on boosting AD, or by reducing taxes.
• During periods of economic growth, governments might use contractionary fiscal policy by decreasing expenditure on purchases and transfer payments.
• Additionally, tax rates might increase. This reduces the size of the government budget deficit.

Question 22

What are exports minus imports (x-m)?

Answer 22

• This is the value of the current account on the balance of payments.
• A positive value indicates a surplus, whilst a negative value indicates a deficit.
• The UK has a relatively large trade deficit, which reduces the value of AD.
• This is the second largest component of AD.

Question 23

What are factors that influence on the (net) trade balances?

Answer 23

• Real income
• Exchange rates
• State of the world economy
• Degree of protectionism
• Non-price factors

Question 24

Factors influencing net trade balances-real income

Answer 24

• During periods of economic growth, when consumers have higher incomes and they can afford to consume more, there is a larger deficit on the current account.

-;When consumers increase their spending, they consume more domestic
products as well as more imports.

• During periods of economic decline, real incomes fall and historically, this has
  led to improvements in the UK’s current account.

Question 25

Factors influencing net trade balances- exchange rates

Answer 25

• A depreciation of the pound means imports are more expensive, and exports
  are cheaper, so the current account trade deficit narrows.
• Depreciations make the currency relatively more competitive against other
  currencies.
• However, it depends on which currency the pound depreciates against.
  -If it is the dollar or euro, it is likely to have a more significant effect, than a currency which is not from one of the UK’s major trading partners.
• Moreover, the demand for UK exports has to be price elastic to lead to an
  increase in exports.
• If demand is price inelastic, exports will not increase significantly, and the value of exports will decrease

Question 26

Factors influencing net trade balances- State of the world economy

Answer 26

• A decline in economic growth in one of the UK’s export markets means there will be a fall in exports.
• This is because consumer spending in those economies will fall, due to falling real incomes.
  o For example, the UK’s largest export market is the EU. If they face an
  economic downturn then demand for UK goods and services will fall

Question 27

Factors influencing net trade balances- degree of protectionism

Answer 27

• Protectionism is the act of guarding a country’s industries from foreign
  competition.
• It can take the form of tariffs, quotas, regulation or embargoes.
• If the UK employed several protectionist measures, then the trade deficit will
  reduce.
  -This is because the UK will be importing less due to tariffs and quotas on imports to the UK.
• However, since protectionism leads to retaliation, exports might decrease
  too, which undoes the effect of reduced imports.

Question 28

Factors influencing net trade balances- Non-price factors

Answer 28

• The competitiveness of a country’s goods and services, which is influenced
  by supply-side policies, impacts how many exports the country has.
• A country can become more competitive by being innovative, having higher
  quality goods and services, operating in a niche market, having lower labour
  costs, being more productive or by having better infrastructure.
  -These increase exports.
• trade deals and being part of trading blocs can influence how much a country exports.
• This either opens up a country to, or closes a country from, significant export opportunities.