4.2.2.3 the determinants of aggregate demand

Question 1

what is the equation of aggregate demand?

Answer 1

AD = C + I + G + (X-M)

aggregate demand = consumption + investment + gov spending + net trade

Question 2

what is consumption?

Answer 2

spending on goods and services

Question 3

what is investment?

Answer 3

• gross domestic fixed capital formation
• investment spending on assets used over a number of years to produce goods and services
• included spending on capital goods (machinery and vehicles) and on working capital (stocks of finished goods and works in progress)
• most volatile component of AD
  -> has huge impacts on the economy

Question 4

what is government spending?

Answer 4

spending on publicly provided goods and services

Question 5

what is the price level?

Answer 5

average prices for all goods and services in an economy
ie. it’s inflation

Question 6

what’s real national output?

Answer 6

the output of an economy taking into account inflation

Question 7

what is the real balance effect?

Answer 7

• as P level rises, the real value of income falls
• meaning consumers, the government and businesses are less reliable to be able to buy what they want or need

Question 8

what is the interest rate?

Answer 8

• as P level rises
• the Bank of England will raise the interest rate which will reduce consumption and investment
  -> will increase saving as this becomes more attractive
  -> borrowing becomes more expensive

Question 9

what are the % abundances of the AD components in the UK?

Answer 9

• consumption = 61%
• investment = 15%
• gov spending = 25%
• net exports = -1%

Question 10

what is the wealth effect?

Answer 10

• in the UK most people own their houses
• means a rise in the price of houses makes people feel wealthier
• likely to spend more

Question 11

what is the level of consumer spending affected by?

Answer 11

• interest rates
  -> variable-rate mortgages will have to pay more each month
  -> less money availed for households to spend on consumption
  -> lower desire for households to engage in credit-financed C
  -> higher reward for saving so consumption falls
• consumer confidence
  -> if they feel their incomes are likely to fall they’ll reduce spending
  -> consumptions no confidence are directly proportional
• taxation
  -> reduces disposable income (especially income tax)
  -> reduces overall C
• wealth
  -> if it increases it’ll have a positive ‘wealth effect’ on households
  -> = they’ll spend more on consumer goods + services
• unemployment
  -> more ppl unemployed and relying on welfare benefits
  -> level of C likely to fall

Question 12

what are the levels of investment affected by?

Answer 12

• interest rates
• demand for exports
  -> increased demand for exports firms make more money
• risk
  -> firms attitude to risk
  -> increase in risky business = increase in investment
• corporation tax
  -> tax on profits - 19% in the UK
• if corporation tax falls, investment increases
• business confidence (keynes - animal spirits)
  -> importance of confidence and gut instinct of business people making decisions
• social costs + benefits
• bank willingness to lend money (access to credit)
• accelerator effect
• MPC and MPS
• APC AND APS

Question 13

what are the levels of government spending affected by?

Answer 13

• policy commitments
  -> use of Fiscal Policy to achieve objectives
  -> fiscal policy = taxation and gov spending
• the government in power
  -> Labour are more likely to increase gov spending
• stage in business cycle
  -> aka economic cycle
• Autumn Statement (now the ‘budget’)
  -> sets out gov plans for taxation ‘ spending / borrowing / forecasts
• Spring Statement
  -> update on outcome

Question 14

what are the factors affecting net trade?

Answer 14

• level of real income
• exchange rate
• quality and other non-price factors
• economic performance of other countries
  -> eg) slow growth in the Eurozone and China
• protectionism
  -> shielding a country’s domestic industries from foreign competition by taxing imports

Question 15

what is the accelerator effect?

Answer 15

increase in national income will lead to a proportionally larger change in investment
eg) increased economic growth -> increased confidence -> increased investment

Question 16

what affects savings?

Answer 16

• interest rates
• rising income enables higher savings
• consumer confidence
• age of individuals
• cultural trends
• wealth (rising house prices increase household wealth)
• inflation

Question 17

what is disposable income?

Answer 17

• the amount of income consumers have left over taxes and social security charges have been removed
• what consumers can choose to spend

Question 18

what is a consumers marginal propensity to consume?

Answer 18

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

Question 19

what is a consumers marginal propensity to save?

Answer 19

the proportion of each additional pound of household income that’s used for saving

Question 20

what is MPC plus MPS equal to?

Answer 20

1

Question 21

what happens at each stage in trade cycle / business cycle?

Answer 21

• real output increase when there’s periods of economic growth, this is the recovery stage
• boom is when economic growth is fast, could be inflationary or unsustainable
• during recessions, gov might increase spending to try and stimulate the economy. could involve spending on welfare payments to help people who have lost their jobs, or cutting taxes
  -> this will increase the gov deficit, and they may have to finance this
• during periods of economic growth, gov may receive more tex revenue since consumers will be spending + earning more
  -> may decide to spend less, the economy doesn’t need stimulating and fewer ppl will be claiming benefits