Aggregate Demand Flashcards
What is aggregate demand?
The t otal demand for goods and services produced within the economy over a period of time.
Formula: consumption + investment + government spending + ( exports- imports)
Why does aggregate demand graph slope downwards?
Wealth effect ( consumption)- as price level decreases, purchasing power of income now increases, people are now richer, people are more likely to spend on goods and services which increases consumption.
Trade effect ( exports - imports)- price level increases, decrease in international competitiveness of UK goods, so decrease in demand for exports and increase in demand for imports. Results in contraction of AD.
Interest effect ( C, I, G, X-M)- higher price level means increased demand for money. As a result interest rates rise, reducing consumption and investment. Contraction in AD.
What is consumption?
Spending by households on goods and services.
What affects consumption?
Level of disposable income- Disposable income relates to the money people have available to spend on goods and services. Cut marginal rate of income tax- increases real disposable income so increases consumption
Interest rates- if they are cut, cost of borrowing falls which encourages consumers to borrow money and spend money on expensive items which increases consumption . If they rise, cost of borrowing rise which increases opportunity cost of saving as more money can be earned by leaving it in the bank. To get money you borrow meaning demand for borrowed funds will rise. However if there is a fixed supply of money available for borrowing from banks, the price of borrowed funds will rise. A rise in interest rates leads to fall in consumption.
Consumer confidence- high consumer confidence, high incentive to spend. Job prospects- if they are secure in their job they are more likely to spend. Level of unemployment is low they will feel more confident in their job and are more likely to spend money.
Asset prices- the wealthier people feel the more likely to spend money. If house prices rise and individuals hold such assets they feel more wealthier which means more likely to spend money the higher the MARGINAL PROPENSITY TO CONSUME.
What are the determinants of savings?
Real disposable income- if incomes rise, savings may rise as well.
Interest rates- higher interest rates means more savings because rate of return increases. Big incentive. High interest rates increase MARGINAL PROPENSITY TO SAVE.
Consumer confidence- if low due to recession or fear of losing jobs they are more likely to save in preparation for that.
What is investment?
Investment is the addition to the capital stock of the economy.
What factors affect investment
Interest rates- if they are low, cost of borrowing is low, firms have a greater incentive to borrow, marginal propensity to invest will be greater when investment is lower.
Business confidence- if expectation of profit is high going forward, then businesses are more likely to invest, marginal propensity to invest will be higher to meet level of demand in the future. If economic growth is likely to be sustained, firms are likely to invest.
Corporation tax- retained profit is profit after corporation tax is paid. Lower the corporation tax, higher retained profit greater potential business has to invest.
Level of competition- if competition is strong, business will react by investing more to get ahead of the competition
What influences government spending?
Trade cycle- this refers to fluctuations in GDP around the long run trend in economic growth. If there is a downturn in economic growth, government expenditure is higher because for example expenditure on welfare benefits is higher. Gov spends more in a recession as government spending increases on out of work benefits. Spend less in a boom.
Fiscal policy- refers to use of government expenditure and taxation to influence the level of economic activity. Governments may deliberately manipulate total spending in the economy by changing their own level of spending. This is called ‘ discretionary fiscal policy’/
What is net trade?
Net trade is calculated by deducting the value of imports from the value of exports
What influences net trade balance?
Income- if incomes rise then there is a reduced incentive for domestic firms to export because they can sell their goods and services in the domestic economy. Also higher income leads to increase in demand for imports.
Changes in exchange rate- if exchange rate rises, net exports are likely to fall because exports are less competitive and imports become more competitive in the domestic economy. SPICED- Strong pound, imports cheaper, exports dear.
What does a movement along the AD graph look like?
The AD diagram if consumption rises.
The AD diagram if consumption falls
The AD diagram if theres a rise in government spending
The AD diagram if theres a rise in interest rates.
