Aggregate Demand

Question 1

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Aggregate Demand

Answer 1

The total demand for goods and services produced in an economy at a given price level and at given time period

Question 2

Why is AD downward sloping?

Answer 2

1. Wealth Effect
   - decrease in price, consumtion increases
   - if people think their assest have a high value, more confident so may consume more as if anything happens they can just sell their assets
2. Interest Rates
   - when price increases, people need to borrow more to afford the goods
   - interest rate increases, cost of borrowing increases so consumption decreases
3. International Trade
   - a rising price level decreases international trade and competitiveness
   - lower demand for net exports

Question 3

Components of AD

Answer 3

1. Consumption
2. Investments
3. Government Spending
4. Net Exports

Question 4

Determinants of consumption

Answer 4

• interest rates
• disposable income
• inflation
• distribution of income
• consume my welfare
• wealth
• age structure of population

Question 5

Determinants of saving

Answer 5

• interest rates
• rise in income
• age structure
• state of financial institution
• confidence and expectations
• government policies

Question 6

Marginal propensity to consume

Answer 6

The proportion of additional income allocated to consumption
- usually between 0 and 1

Question 7

MPC

Answer 7

change in consumption / change in income

Question 8

What does the level of consumption depend upon?

Answer 8

• how much consumers are taxed
• depends on MPC
• type of good

Question 9

Marginal propensity to save

Answer 9

The proportion of additional income that is allocated to saving

Question 10

MPS

Answer 10

change in savings / change in income

Question 11

Life cycle hypothesis (Franco Modigiliani)

Answer 11

Individuals seek to smooth consumption over the course of a lifetime
- borrowing when low income and saving when high income

Question 12

Individuals in Life Cycle Hypothesis

Answer 12

1. Students
- will take out student loans and so spend a lot instead of saving

2. Working aged individuals
- want to save more money to smooth consumption
- save money for mortgages and retirement

3. Retirees
- don’t need to save anymore and so spend a lot
- may sell off wealth too smooth consumption
- lots of leisure times or spend more

Question 13

What else keeps consumption stable beside income?

Answer 13

Wealth

Question 14

Limitations of the life cycle hypothesis

Answer 14

• irrationality
• lack of information
• present focused bias
• unwilling to run down wealth

Question 15

What does the extent to which the life cycle hypothesis is plausible depend on?

Answer 15

1. High or Low income
- high income earners will save as they have already met their needs and once and still have money left over
- high income earners have lots of financial knowledge
- low income earners will spend more as they don’t have the privilege to save as have not met needs and wants

2. Developed or developing country
- developed countries have a welfare state and better financial institutions
- in developed countries government gives up pensions and benefits so less likely to save
- in undeveloped countries they may not have a secure government or financial institution to trust so may save at home
- dont have a welfare state in developing countries

Question 16

Permanent income hypothesis (Milton Friedman)

Answer 16

Consumers do not make decisions based on current income only but instead permanent income
- depends on income they expect for the next few years

Question 17

Why will consumption not necessarily change dramatically?

Answer 17

If consumers perceive changes in their income to be temporary so we’ll not change consumption patterns massively

Question 18

Limitations of the permanent income hypothesis

Answer 18

1. Low/High income households
- if low income household gets a large summer money they have high pressure to consume more to meet needs and wants
- high income households tend to save as they can already afford and met their needs

2. Unexpected increase in windfall
- when increase in bonuses people tend to save more

3. Subjectivity
- Some people may perceive permanent and temporary income differently

Question 19

Investment

Answer 19

The addition of capital stock of the economy

Question 20

Why is investments so volatile?

Answer 20

Investments rely on business confidence so if firms feel more confident they are more willing to invest

Question 21

Determinants of investments

Answer 21

• rise in disposable income
• interest rates
• level of profit
• corporation tax
• subsidies
• capacity utilization

Question 22

What do firms expectations and confidence impact in an economy?

Answer 22

• employment
• inflation
• changes in output

Question 23

What do firms consider when deciding to spend on investments?

Answer 23

• whether they will make a higher return from their investments
• if the Investment lowers their cost of production

Question 24

What does the extent to which firms will invest depend upon?

Answer 24

1. Government policies
- if low tax, consumption and profit increases
- relaxed labour laws means firms can pay lower wages and have more workers

2. Means of investment
- depends on how risky the Investment is
- depends on if they have retained profit
- depends on if the bank trust the firm to give loans

3. Competitive fundamental of an industry
- depends on how many competitive firms in the industry
- depends on if they are the dominant firm in the industry

Question 25

Government spending

Answer 25

Spending by central and local government on things like education and healthcare

Question 26

Determinants of government spending

Answer 26

• ideological prioritizations
• market failure
• pleasing electoral votes
• International circumstancing
• level of economic activity

Question 27

Net exports

Answer 27

Exports - Imports

Question 28

Trade Surplus

Answer 28

exports > imports

Question 29

Trade Deficit

Answer 29

imports > exports

Question 30

Determinants of net exports

Answer 30

• trade barriers
• domestic income
• a broad income
• exchange rates
• domestic price level
• non-price factors