4.10.3 - The Determinants of Aggregate Demand

Question 1

What are the determinants of consumption?

Answer 1

• Interest rates
• The level of income
• Expected future outcome
• Wealth
• Consumer confidence
• The availability of credit
• Distribution of income
• Expectations of future inflation

Question 2

What is the rate of interest?

Answer 2

The reward for lending savings to somebody else (i.e. a bank) and the cost of borrowing.

Question 3

What happens when rates of interest rise?

Answer 3

People will be more likely to save and the amount consumed will fall.

Question 4

What is the Keynesian theory of consumption and saving?

Answer 4

“… men are disposed, as a rule and on average, to increase their consumption as their income increases, but not by as much as the increase in their income.”

i.e. absolute consumption will rise, but consumption falls as a fraction of total income.

Question 5

Why may absolute income not be the greatest determinant of consumption?

Answer 5

Planned consumption may be more influenced by a notion of expected income over a much longer time period.

Many people save based on the notion of income over their life i.e. pensions, and people will contribute to this regardless of temporary fluctuations in annual incomes.

Question 6

What is the life-cycle theory of consumption?

Answer 6

A theory that explains consumption and saving in terms of how people expect their incomes to change over the whole of their life cycles.

Question 7

How is wealth a determinant of consumption?

Answer 7

The stock of wealth (which for most people involves houses and cars) will fluctuate.

As wealth rises (i.e. house prices rise), there is a ‘feel-good’ factor amongst property owners, and consumer spending increases. The inverse is also true.

Question 8

How is consumer confidence a determinant of consumption?

Answer 8

When consumer optimism changes (likely due to expected income and wealth), consumer consumption changes.

When consumer optimism increases, consumer consumption also increases. The inverse is also true.

Question 9

What is the availability of credit?

Answer 9

Funds available for households and firms to borrow.

Question 10

What is the credit crunch?

Answer 10

Occurs when there is a lack of funds available in the credit market, making it difficult for borrowers to obtain financing, and leads to a rise in the cost of borrowing.

Question 11

How does the availability of credit influence consumption?

Answer 11

If credit is available easily and cheaply, consumption increases as people supplement current income by borrowing.

In the inverse, the credit crunch after the ‘08 financial crisis involved interest rates rising and the supply of credit drying up.

Question 12

How does the distribution of income influence consumption?

Answer 12

Rich people save a greater proportion of their income than poor people, so redistribution of income from rich to poor will increase consumption.

Question 13

What is the distribution of income?

Answer 13

The spread of different incomes among individuals and different income groups in the economy.

Question 14

How do expectations of future inflation affect consumption?

Answer 14

Uncertainty caused by fears of rising inflation increases precautionary saving and therefore reduces consumption.

Question 15

What is the personal savings ratio?

Answer 15

Realised or actual personal saving / personal disposable income.

Measures the actual or realised saving of the personal sector as a ratio of total personal sector disposable income.

Question 16

What is the distinction between saving and investment?

Answer 16

Saving is income that is not spent on consumption.

Investment is spending by firms on capital goods such as machines and office equipment.

Question 17

What does a country’s gross investment include?

Answer 17

• Replacement investment
• Net investment

Question 18

What is replacement investment?

Answer 18

Maintains the size of the existing capital stock by replacing worn-out capital.

Question 19

What is net investment?

Answer 19

Adds to the capital stock, thereby increasing productive potential.

Question 20

What influences investment decisions?

Answer 20

• Rate of interest
• The relative prices of capital and labour
• The nature of technical progress
• The adequacy of financial institutions in the supply of investment funds

Question 21

How does the rate of interest influence investment decisions?

Answer 21

Firms need to form views on expected future sales revenue attributable to the investment project and expected future costs of production, resulting from both the rate of interest paid and from future maintenance costs.

Question 22

How do the relative prices of capital and labour influence investment decisions?

Answer 22

When the price of capital rises, firms will adopt more labour-intensive methods of production, substituting labour for capital. And in the inverse.

Question 23

How does the nature of technical progress influence investment decisions?

Answer 23

Technical progress makes machinery obselete or out of date.

In this case, a machine’s business life becomes shorter than its technical life (the number of yeras before a machine wears out).

Question 24

How does the adequecy of financial institutions in the supply of investment funds influence investment decisions?

Answer 24

Investments in fixed capital goods are long-term investments that yield expected income years into the future.
These investments may be difficult to finance because of the inadequacy of the financial institutions that provide investment funds.

Question 25

What is the accelerator?

Answer 25

A change in the level of investment in new capital goods induced by a change in national income or output.
The size of the accelerator depends on the economy’s capital-output ratio.

Question 26

What assumption does the accelerator process stem from?

Answer 26

You assume that firms wish to keep a relatively fixed ratio, known as the capital-output ratio, between the output they are currently producing and their existing stock of fixed capital assets.