4. Aggregate Demand and Circular flow of income

Question 1

Aggregate Demand Definition

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 Aggregate Demand

Answer 2

Household spending on goods and services (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)

Question 3

Formula for Aggregate Demand

Answer 3

The formula for aggregate demand is
expressed as: AD = C+I+G+(X-M)

C+I+G = domestic demand
(X-M) = net exports (trade balance)

Question 4

The Aggregate Demand Curve

Answer 4

The aggregate demand curve shows
a relationship between aggregate
demand and the general price level.

Question 5

Marginal propensity to consumer and save

Answer 5

MPC = Change in Consumption / Change in income
MPS = Change in saving/ change in income
MPC + MPS = 1

Question 6

Marginal propensity to export and import

Answer 6

MPX = change in exports / change in income
MPM = change in imports / change in income

Question 7

Determinants of X-M

Answer 7

1. Exchange rates
   -depreciation. If ER down -> MPX ^ -> X ^ -> AD ^
   - appreciation. If ER up -> MPX down -> X down -> AD down
2. Real disposable income earned abroad
   MPX ^ -> X ^ -> AD down
3. real disposable income earned at home
   MPM ^ -> M^ -> AD down
4. Gov’t restrictions of free trade
   (X-M) = 0

Question 8

Determinants of consumption

Answer 8

1. Real disposable income
   DI^ -> MPC^ -> C^ -> AD^
2. Interest rates
   i^ -> MPS^ -> S^ -> AD down
3. Consumer confidence
   CC^ -> MPC^ -> C^ -> AD^
4. Wealth (Asset Prices)
   if Wealth ^ - > MPC^ -> C^
5. Household indebtedness if high
   MPS^ -> S^ -> AD down
6. Anticipated inflation
   if I^ -> MPC^ -> C^ -> AD^

Question 9

Determinants of saving

Answer 9

1. Level of real disposable income
   increase in RDI -> MPC ^ -> C^ -> AD^
   2.Interest rates
   i^ -> MPS^ -> S^ -> AD shifts left
2. Consumer confidence
   CC^ -> MPS down -> S down
   4.The range and trust worthiness of FIs
   Trustworthiness ^ -> MPS ^ -> S^ -> AD down
3. Tax incentives
   MPS^ -> S^ -> AD down

Question 10

Determinants of Investment

Answer 10

1.Interest rates
interest rates down -> cost of borrowing down -> MPC ^ / I^ -> AD shifts right
2. Level of corporate tax
CT ^ -> MPS^ -> Investment down -> G tax -> AD down
3.Business confidence in future expectation
if down -> MPI down -> Investment down
Economy well:Bull market
Not well : Bear market
4. Capacity utilisation
Higher CU -> MPI ^ -> investment ^ -> AD ^
5. Rate of growth of technology and competition
if decrease -> MPI down -> investment down -> AD down
6. Price of capital stock
if increase CS^ -> MPI down -> Investment down -> AD decreases

Question 11

Determinants of government spending

Answer 11

1. Influence of economic activity
   economic activity decreases -> GDP down -> Gov’t spending ^ -> firm contrast infrastructure -> consumer confidence -> consumption^ -> AD ^
2. To crrect market failure and increase efficiency
   G^ -> AD^
   State schools are examples of market failures, gov’t has to provide this.
3. Reduce inequality to increase equity
   G^ -> Equity^ -> DI ^ -> AD ^
   Equity is fairness for all

Question 12

Examples of capital investment

Answer 12

Robotics, integrated plants, machine tools, Infrastructure, software, logistic

Question 13

Investment spending

Answer 13

is about the purchase of capital/ the addition to the economies capital stock

Question 14

Savings definition

Answer 14

represent the total amount of income that is not consumed by households, businesses or the government.

Question 15

Capital investment

Answer 15

is the spending on machiney, equipment, factories, technologies and infrastructure to create new capital goods

Question 16

Gross investment

Answer 16

is the total amount that the economy spends on new capital.

Question 17

Net investment formula

Answer 17

Gross investment - capital depreciation

Question 18

Factors affecting planned business investment

Answer 18

Actual & expected demand for G&S
Expected profits and business taxes.
interest rates and availability of business finance
Business confidence i.e. Animal spirits

Question 19

The basic accelerator effect

Answer 19

it is a positve relationship between planned investment and the rate of change of national income.
If an industry is having rising demand then then a firm will respond by running down stock, if they expect sustained high demand they will invest in machinery to increase supply capacity. A rise in demand in consumer goods causes a rise in demand for capital goods.

Question 20

Animal spirits

Answer 20

John Maynard keynes made the notion of animals spirits which is a mix of confidence, trust, mood and expectations.

Question 21

Significance of investment for the economy

Answer 21

• injection of demand for the economy.
• Investment can life productivity incomes
• Economies of scale and better competitiveness
• Investment helps to sustain export led-growth.

Question 22

What is the multiplier process?

Answer 22

• the multiplier effect occurs when an intial change in spending leads to a larger impact on total economy or income.
• It shows how changes in spending can trigger a ripple effect throughout of economy.
• Increased spending by individuals gives recipients more income, which they spend on G&S.
• This creates additional demand, prompting businesses to increase production to hire more workers, leading to factor incomes.

Question 23

Positive multiplier effct

Answer 23

leads to a greater final increase in the level of GDP.

Question 24

Negative multiplier effect

Answer 24

leads to a greater final decrease in the level of GDP.

Question 25

Simple multiplier formula

Answer 25

in a closed economy with no government sector, the multiplier shows the impact of a change in investment on national income.
Multiplier = 1/ Marginal propensity to save or
Multiplier = 1/(1-MPC)

Question 26

Extended multiplier formula

Answer 26

Multiplier = 1/ (MPS + MPM + MRT)
In an economy with a government sector there are three withdrawals from the circular flow
1. Savings (MPS)
2. Imports (MPM)
3. Taxation (Marginal tax rate of income)

Question 27

What factors affect the multiplier value?

Answer 27

• a higher MPC leads to more income being spent if income were to increase.
• leakages reduce the size of the multiplier
• if an economy is operative close to its full potential the multiplier is limited
• time frame

Question 28

Key factors influencing consumer spending

Answer 28

changes in real disposable income
level of employment & job security
cost of consumer credit
cost of a mortgage
wealth effect - changes in asset prices
Future expectations

Question 29

The marginal propensity to consume

Answer 29

is the change in the consumer spending arising from a change in disposable income.

Question 30

Marginal propensity to save

Answer 30

is the change in saving because of a change in household disposable income

Question 31

Household saving ration

Answer 31

measures the amount of money households have to save.
This savings ratio is measured as a percentage of total disposable income.

Question 32

Household debt, consumption and Saving

Answer 32

When households borrow money with a credit card, this is called dis-saving. This is because borrowing allows them to spend more than their disposable income. Consumers spending often rises quickly when credit is easily available and when interest rates are relatively low. The household debt to income ratio is a measure of the scale of debt in a country.