Aggregate Demand

Question 1

AD calculation

Answer 1

• Aggregate demand + Consumption + Investment + Government spending + (Exports - Imports)
• AD = C+I+G+(X-M)

Question 2

AD

Answer 2

• Aggregate demand is the total demand in the economy at a given price level
• The AD curve shows the equilibrium level of expenditure at each price level
• Real output = Real expenditure = Real income

Question 3

Consumption

Answer 3

• Disposable income (household income after tax) is either spent or saved - the spending portion is what is known in economics as consumption
• In the UK this is the most significant component of AD making up over 65%
• The effect of various factors on the amount a household consumes is called the consumption function*

Question 4

Factors determining the level of consumption

Answer 4

• Income
• Rise in income leads to increase in consumption
• The size of the effect of a rise in income is determined by the marginal propensity to consume (MPC)
• MPC = Change in consumption / Change in income. (expressed as a decimal).
• Average propensity to consume (APC) measures the amount spent on consumption out of total income
• APC = Consumption / Income

Question 5

Consumption function*

Answer 5

• Ignoring taxation, any household income can either be consumed or saved
• Keynes believed that as income rises, consumption will rise more slowly than savings
• The higher your income, the more you can afford to save

Question 6

Stock of assets

Answer 6

• Household wealth consists of physical wealth and monetary (or financial) wealth

Question 7

Wealth effect

Answer 7

• Change in consumption caused by changes in consumption caused by changes in household wealth
• As wealth increases there is a psychological confidence effect that tends to increase consumption (consumer confidence)
• This reduce saving as much of there savings are already rising and so they can spend more

Question 8

Interest rates

Answer 8

• Influence spending on durables directly, on non-durables through reduced variable rate mortgage payments, and can also trigger a wealth effect by influencing stock prices and house prices

Question 9

Inflation

Answer 9

• There are conflicting impacts
• Households may bring more forward expenditure to beat future price rises
• They may increase saving to protect the value of there overall wealth
• The short term spending may outweigh saving
• Over time saving is predominant
• Meaning inflation has a negative impact on consumption

Question 10

Availability of credit

Answer 10

• Post financial crisis of 2008/9 banks have more reluctant to lend to households
• More widely available credit leads to increased consumption as people borrow to bring forward consumption
• Deregulation of banks and the credit industry in the 1980s led to a “consumer boom”

Question 11

Confidence

Answer 11

• Consumer confidence with increased incomes will increase consumption
• In contrast if households a pessimistic for the future they will increase savings and reduce consumption
• Expectations of future inflation are also important, low predictable inflation should increase consumer confidence

Question 12

Demographics

Answer 12

• Younger and older people have a higher MPC and APC but also lower incomes.
• Savings for pensions and mortgages are at its highest from 30s to 50s where incomes are likely highest

Question 13

Investment

Answer 13

• Investing is spending by firms on human and physical capital with the aim of increasing productivity or productive potential
• Government also invest in infrastructure however it fits under G in the equation

Question 14

Mal-investment

Answer 14

• The term given to investment in areas that do not yield improvements in productivity or productive potential

Question 15

Factors determining the level of investment in an economy

Answer 15

• Accelerator theory
• Net investment
• Capital replacement
• Gross investment
• The marginal efficiency of capital theory (MEC)

Question 16

Accelerator theory

Answer 16

• Suggests that investment varies with rate of change in output, income, AD rather than the interest rate being the biggest factor

Question 17

Net investment

Answer 17

• An increase in the capital stock - more capitals exists than previously

Question 18

Capital replacement

Answer 18

• Means replacing existing capital that is worn out

Question 19

Gross investment

Answer 19

Is net investment + capital replacement

Question 20

MEC

Answer 20

• Tells us that at higher interest rates, fewer investment projects are worthwhile and fewer will be undertaken.
• Firms compare the return rate on investing in capital with the cost of capital
• Investment therefore falls
• Investment rises as interest rates fall and investment falls as interest rates rise

Question 21

Other factors that influence investment levels

Answer 21

• Levels of profit - used by firms to reinvest in their business
• Costs of capital goods
• Technological changes - to increase efficiency or simply keep up with competitors
• Expectation of inflation
• Business/ consumer confidence
• Government policy - tax breaks for firms who invest more

Question 22

Government spending

Answer 22

• Assumed to be exogenously determined, by politicians of the day

Question 23

Automatic stabilisers

Answer 23

• Described increase in govt spending that occur in a recession or reduce in a boom
• e.g. welfare payments will rise because more people are unemployed.
• At the same time, tax revenue falls as incomes, expenditures and profits are all lower
• With greater injections that leakages the automatic stabilisers help the economy “turn a corner”

Question 24

Discretionary spending

Answer 24

• The spending that the government decide to do
• It is financed by taxation and government borrowing (issuing govt bonds)
• There fore it may be influenced by the amount of tax that can be raised and the availability of a loan finance and the interest required to sell govt bonds
• Govt spending may also be influenced by structural changes like ageing population or by cyclical influences such as spending more in a recession
• However some economists argue that increased govt spending can result in falling consumption or the “crowding out” of investment. This is due to either taxes having to rise to fund spending or govt borrowing more which causes commercial interest rates to rise or it displaces private sector spending as resources are diverted to govt projects

Question 25

Exports and import (X-M)

Answer 25

• The level of exports and imports is primarily determined by price
• Higher prices will reduce exports (more expensive) and increase imports (relatively cheaper)

Question 26

The price of Exports and Imports will depend on

Answer 26

• The efficiency of production (productivity)
• The rate of inflation
• The exchange rate

Question 27

Exchange rate

Answer 27

• When a currency strengthens (appreciates) it can buy more of another currency
• This means imports get cheaper because fewer pounds have to be given up to buy $ to buy the imports
• However exports become more expensive for those foreign consumers who have to give up more of their currency to the £

Question 28

SPICED

Answer 28

SP - Strong Pound
IC - Imports cheaper
ED - Exports Dearer

Question 29

Other factors affecting X-M

Answer 29

• Higher incomes
• The structure of the economy - The UKs services based economy means we import lots of manufactured goods, and many services are not exportable. The UK runs a semi-permanent current account deficit, financed by money inflows from selling off financial and physical assets and by firms borrowing from abroad