4. Aggregate Demand and Circular flow of income Flashcards
Aggregate Demand Definition
total planned real expenditure on a
country’s goods and services
produced within an economy in each
time period.
Components of Aggregate Demand
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)
Formula for Aggregate Demand
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)
The Aggregate Demand Curve
The aggregate demand curve shows
a relationship between aggregate
demand and the general price level.
Marginal propensity to consumer and save
MPC = Change in Consumption / Change in income
MPS = Change in saving/ change in income
MPC + MPS = 1
Marginal propensity to export and import
MPX = change in exports / change in income
MPM = change in imports / change in income
Determinants of X-M
- Exchange rates
-depreciation. If ER down -> MPX ^ -> X ^ -> AD ^
- appreciation. If ER up -> MPX down -> X down -> AD down - Real disposable income earned abroad
MPX ^ -> X ^ -> AD down - real disposable income earned at home
MPM ^ -> M^ -> AD down - Gov’t restrictions of free trade
(X-M) = 0
Determinants of consumption
- Real disposable income
DI^ -> MPC^ -> C^ -> AD^ - Interest rates
i^ -> MPS^ -> S^ -> AD down - Consumer confidence
CC^ -> MPC^ -> C^ -> AD^ - Wealth (Asset Prices)
if Wealth ^ - > MPC^ -> C^ - Household indebtedness if high
MPS^ -> S^ -> AD down - Anticipated inflation
if I^ -> MPC^ -> C^ -> AD^
Determinants of saving
- Level of real disposable income
increase in RDI -> MPC ^ -> C^ -> AD^
2.Interest rates
i^ -> MPS^ -> S^ -> AD shifts left - Consumer confidence
CC^ -> MPS down -> S down
4.The range and trust worthiness of FIs
Trustworthiness ^ -> MPS ^ -> S^ -> AD down - Tax incentives
MPS^ -> S^ -> AD down
Determinants of Investment
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
Determinants of government spending
- Influence of economic activity
economic activity decreases -> GDP down -> Gov’t spending ^ -> firm contrast infrastructure -> consumer confidence -> consumption^ -> AD ^ - To crrect market failure and increase efficiency
G^ -> AD^
State schools are examples of market failures, gov’t has to provide this. - Reduce inequality to increase equity
G^ -> Equity^ -> DI ^ -> AD ^
Equity is fairness for all
Examples of capital investment
Robotics, integrated plants, machine tools, Infrastructure, software, logistic
Investment spending
is about the purchase of capital/ the addition to the economies capital stock
Savings definition
represent the total amount of income that is not consumed by households, businesses or the government.
Capital investment
is the spending on machiney, equipment, factories, technologies and infrastructure to create new capital goods
Gross investment
is the total amount that the economy spends on new capital.
Net investment formula
Gross investment - capital depreciation
Factors affecting planned business investment
Actual & expected demand for G&S
Expected profits and business taxes.
interest rates and availability of business finance
Business confidence i.e. Animal spirits
The basic accelerator effect
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.
Animal spirits
John Maynard keynes made the notion of animals spirits which is a mix of confidence, trust, mood and expectations.
Significance of investment for the economy
- injection of demand for the economy.
- Investment can life productivity incomes
- Economies of scale and better competitiveness
- Investment helps to sustain export led-growth.
What is the multiplier process?
- 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.
Positive multiplier effct
leads to a greater final increase in the level of GDP.
Negative multiplier effect
leads to a greater final decrease in the level of GDP.
Simple multiplier formula
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)
Extended multiplier formula
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)
What factors affect the multiplier value?
- 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
Key factors influencing consumer spending
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
The marginal propensity to consume
is the change in the consumer spending arising from a change in disposable income.
Marginal propensity to save
is the change in saving because of a change in household disposable income
Household saving ration
measures the amount of money households have to save.
This savings ratio is measured as a percentage of total disposable income.
Household debt, consumption and Saving
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.
