AD curve Flashcards
Explain the AD curve
Shows the relationship between the level of real planned expenditure and the general price level in an economy
AD = C + I + G + X – M
A fall in the general price level (PL) causes an extension of AD (movement along the AD curve, higher real Y).
A rise in the PL causes a contraction of AD (movement along AD curve, lower real Y).
How has the real income effect caused an inverse relationship between AD and price levels?
As the price level falls, the real value of
income rises, consumers can buy more; higher consumption C
(the real money balance effect)
How has the balance of trade effect caused an inverse relationship between AD and price levels?
A fall in the relative price level of a
country could make foreign-produced goods more expensive,
causing a rise in exports, X and a fall in imports, M
How has the interest rate effect caused an inverse relationship between AD and price levels?
If price inflation is low this might lead to a
reduction in interest rates and so there is less incentive to save and consumption C rises; the exchange rate could also depreciate and improve net exports (X-M).
Descri
Any change that causes AD to increase other than a change in the PL shifts AD to the right from AD1 to AD3
Any change that causes AD to decrease other than a change in the PL shifts AD to the left from AD1 to AD2
How do changes in real income and employment shift AD?
When the economy is growing and
inflation is stable, people’s real incomes increase as does their job security. This
gives people the disposable income and confidence to spend more. Consumption C
increases, boosting AD. Higher C may lead to more investment I as businesses
expand to meet the higher consumer demand.
How do changes in consumer and business confidence (Keynes’ animal spirits) shift AD?
When there is high consumer and business confidence in the economy, both consumption C and investment I demand grow. Confidence is affected by a multitude of factors – economic news, market sentiment, policy changes etc.
How do Changes in household wealth – the ‘wealth effect’ shift AD?
When assets prices increase,
then people begin to feel wealthier. Homeowners see similar houses to theirs
increasing in value; shareholders see the value of their holding go up. This gives
households more confidence to spend rather than save and encourages them to
take out more loans, secured against their higher valued assets. C increases adding
to AD. (Negative wealth effect does the opposite)a
How do changes in monetary policy’ shift AD?
Lower interest rates make saving less attractive and
borrowing cheaper, so consumers are more likely to spend; mortgage holders may
also find their mortgage interest payments fall giving them more spending income;
businesses are more likely to invest because borrowing costs are lower and saving
any retained profit gives a lower return
How do changes in fiscal policy’ shift AD?
The government can increase its own consumption G
and/or public investment I. It can fund this via more government borrowing.
Cutting income tax can boost C; cutting indirect taxes such as VAT can cause
consumer confidence to rise; cutting corporation tax may encourage more I. All
these can cause AD to increase
How do Changes in the exchange rate and in the global economy shift AD?
a depreciation reduces
export prices and increases import prices so net exports rise; global growth can
also boost net exports (X-M)
