Aggregate Demand Flashcards
Define Aggregate Demand?
The total demand for goods and services in an economy at a given price level in a given time period.
What four components is Aggregate Demand divided into?
- Consumption
- Investment
- Government spending
- Foreign Purchases
What comes under consumption?
Household spending
What comes under investment?
Spending by firms
What isn’t included in government spending in AD?
It does not include transfer payments like benefits.
What comes under and what doesn’t come under foreign purchases in AD?
- Foreign purchases includes exports
- Foreign purchases does not include imports because imports are not made by the economy.
What is the formula for AD?
AD=C+I+G+(X-M)
AD= consumption+investment+government spending+(exports-imports
What goes on the X axis on the AD curve?
Real GDP
What goes on the Y axis on the AD curve?
Price Level
If the price level is high…
The national output is low
If the price level is low…
The national output is high
What’s the largest component of AD?
Consumption
What are the 8 determinants of consumption?
1) Income
2) Wealth
3) Rate of Interest
4) Tax
5) Availability of credit
6) Expectations
7) Age Distribution
8) Inflation
What impact should an increase in Income have on consumption?
An increase in income should lead to more consumption.
What is Marginal Propensity to Consume (MPC)?
The percentage of extra income spent.
What is the formula for MPC?
MPC= change in consumption/change in income
What is the difference between wealth and income?
Wealth is a stock, income is a flow.
What makes up wealth?
money+assets (that have a realistic monetary value)
What is the wealth effect?
Where a rising asset value leads to increased confidence to spend, even though they don’t have any more money.
What form of inflation to governments generally think is good to do with the wealth effect, and why?
Governments believe that rising house prices are the only good form of inflation because it encourages consumption.
What effect does the interest rate to do with savings have on consumption?
The interest rate changes the opportunity cost of inflation. If there is a high interest rate then saving may seem like a better option than consuming.
What is the opportunity cost of consumption?
Saving
What effect does the interest rate to do with borrowing have on consumption?
- The interest rate affects the decision and the ability to borrow. A low interest rate may persuade more people to borrow, which would boost consumption.
- Also if a person has a variable rate mortgagee then that changes a persons disposable income, however fixed rate mortgages will not.
What is an example of a direct tax?
Income tax
What is an example of an indirect tax?
VAT
What’s the relationship between change in tax and consumption?
-Decrease tax, increase consumption.
What effect does availability of credit have on consumption?
If credit is more available then people are more likely to borrow and therefore spend.
What effect do economic expectations have on consumption?
-People speculate into the future conditions of an economy. If the condition of the economy looks good then they will be more likely to spend.
What effect does age distribution have on consumption?
Different age groups have different spending patterns.
What negative effect does inflation have on consumption?
If prices increase then people will spend less.
What positive effect could inflation have on consumption?
Potentially people speculate about further increases in price in the future so they spend more now.
Define investment?
Spending by firms on capital goods
What are the three determinants of investment?
- Expected future demand
- Price of capital goods
- Advances in technology
What is the impact of the interest rate on investment?
- Much of investment spending is financed by borrowing.Therefore the cost of borrowing is an important factor in an investment decision.
- A high rate of interest may make an investment project unattractive in terms of its cost.
- A firm hopes to make a profit from an investment, but if the interest rate is high then the overall cost of the investment may be too high for it to make a profit.
- Even if a firm finances investment from its own funds, the interest rate is still relevant. A high rate may make saving the money more attractive.
Why may a government want to encourage investment?
- It keeps the economy active (more AD)
- It helps to sell exports.
What can a government do to encourage investment?
- Lower the rate of corporation tax
- Provide investment subsidies.
What effect would lowering the rate of corporation tax have on investment?
Lowering the rate of corporation tax would lower the cost of investment to a firm, thus increasing investment.
What effect would providing investment subsidies have on investment?
Investment subsidies would encourage investment by firms because it would lower the cost of investment for a firm.
What is the impact of business expectations on investment?
Firms may undertake investment to expand capacity if encouraged by optimistic forecasts of future growth and demand for their products. The amount of expected profit will be a key determinant.
What is the impact of changes in technology on investment?
New products create new sales opportunities, thus increase in investment.
What are the two categories of government spending?
- Capital spending
- Current spending.
What are some examples of government capital spending?
- HS2
- Armed forces weapons
- hospital equipment
What are some examples of government current spending?
- upkeep of parks
- -running a state broadcaster
- -electricity bills for government buildings.
Determinants of government spending?
- Position in the electoral system
- Position in the economic cycle
- Ideology
- Government income/cost of borrowing
What impact does the business cycle have on government spending?
It has an important impact on the level of government income transfers. Movement into recession will increase social security payouts
What are the determinants of export spending?
- The business cycles
- Trade competitiveness.
What factors determine trade competitiveness?
- Comparative productivity
- The determinants of higher productivity
- Exchange rates
