Aggregate Demand 2.2

Question 1

Define Aggregate Demand,

Answer 1

Total amount of planned spending of goods and services in an economy at any given price level.

Question 1

What is the formula for AD?

Answer 1

AD = C + I + G + (X-M)

Question 2

What is the consumption component of AD?

Answer 2

Consumption is consumer spending on goods and services; it makes up about 60% of AD.

Question 3

What is the investment component of AD?

Answer 3

-Investment is spending by business on capital goods, such as new equipment and building as well as working capital e.g. stocks and work in progress; it makes up about 15%-20% of AD.

-75% of investment is by the private sector but there is also investment by the government.

Question 4

What is the government spending component of AD?

Answer 4

-Government spending is spending by the government on providing goods and services, generally public and merit goods, both on wages and salaries of public sector workers and on investment goods like new roads and schools.

-It makes up around 25% of AD.

Question 5

What is the net export component of AD?

Answer 5

-Net exports is exports minus imports (X-M): when imports are higher than exports this a minus figure as more leaves the UK than comes in.

-Although the UK has a large trade deficit, the net export component is a minor figure as it is the least significant part of AD at around 5%.

Question 6

Why is the AD curve downward sloping?

Answer 6

A rise in prices causes a fall in real GDP.

Question 7

A rise in prices causes of fall in real GDP.

What are the four reasons for this?

(IE)

Answer 7

Income effect: As a rise in prices is not matched straight away by a rise in income, people have lower real incomes so can afford to buy less, leading to a contraction in demand.

Question 8

A rise in prices causes of fall in real GDP.

What are the four reasons for this?

(RBE)

Answer 8

Real balance effect: A rise in prices will mean that people’s savings will no longer be worth as much and so will offer less security. As a result, they will save more and so reduce their consumer spending. Consumption is of component of AD so there is a contraction in AD.

Question 9

A rise in prices causes of fall in real GDP.

What are the four reasons for this?

(SE)

Answer 9

Substitution effect: If prices in the UK rise, less foreigners will want to buy British exports and more and more UK residents will want to buy imported foreign goods because they are cheaper. The rise in imports and fall in exports will decrease the net exports (X-M) so AD becomes smaller.

Question 10

A rise in prices causes of fall in real GDP.

What are the four reasons for this?

(IRE)

Answer 10

Rising prices means firms have to pay their workers more and so there is a higher demand for money. If supply stays the same, then the ‘price of money’ will rise i.e. interest rates will rise because of higher demand. Higher interest rates mean that more people will save and less will borrow and will also mean that businesses will invest less, so AD will contract.

Question 11

Define consumption.

Answer 11

Consumption is the spending on consumer goods and services over a period of time.

Question 12

Define disposable income (Y)?

Answer 12

Disposable income is the money consumer have left to spend, after taxes have been have deducted and any state benefits have been added.

Question 13

Disposable income is the most important factor in determining the level of consumption.

Why is this?

Answer 13

Those who are earning a large income will able to spend much more than those on a minimum wage.

Question 14

What is the marginal propensity to consume?

Answer 14

MPC : How much an increase in income affects consumption.

Question 15

Why do poorer people tend to have a higher MPC than richer people?

Answer 15

Poorer people tend to have a higher MPC as they are likely to spend much more of their increase in income whilst richer people are more likely to save it.

Question 16

What is APC?

Answer 16

The average propensity to consume (APC) is the average amount spent on consumption out of total income.

Question 17

What is the formula for MPC?

Answer 17

MPC = change in consumption/change in income.

Question 18

What is the formula for APC?

Answer 18

APC = total consumption/total income.

Question 19

An increase in consumption…

Answer 19

decreases savings.

Question 20

What is the marginal propensity to save?

Answer 20

The marginal propensity to save (MPS) is how much of an increase in income is saved.

Question 21

What is the formula for MPS?

Answer 21

MPS = change in savings / change in income.

Question 22

What is the formula for APS?

Answer 22

APS = total savings/total income.

Question 23

How to interest rates influence consumer spending?

Answer 23

Most major expenditures are bought on credit so therefore the interest rate will affect the cost for the good for consumers.

If interest rate are high, the price of the good will effectively be higher since more interest needs to paid back (e.g. mortgage repayments will increase), leading to a reduction in consumption.

A rise in interest rates decreases the value of shares and so people experience a negative wealth effect.

Question 24

How does consumer confidence influence consumer spending?

Answer 24

If people are confident about the future and expect pay rises, then they will continue to increase their spending.

If people expect high levels of inflation in the future, they will buy now as good/services will be at a cheaper price, so consumption will increase. This is the same for taxes.

However,

If people expect a recession and fear possible unemployment, consumption will decrease as people may save more.

Question 25

How does the wealth effect (for housing) influence consumer spending?

Answer 25

Wealth is a stock of assets. The wealth effect is the change in consumption following a change in wealth. Greater wealth will improve consumer confidence and thus lead to greater spending.

The wealth effect is experienced when real house prices rise as owners now have more wealth so are more confident with spending. This is because house owners know that if they go into financial difficulty they could simply borrow more against the house, since their house is worth more than their current mortgage.

Question 26

How does the wealth effect (for share prices) influence consumer spending?

Answer 26

When share prices rise people may sell some of their shares and spend the money. Also, people may be more confident is spending the money they already have as they know they have shares to fall back on in case of financial difficulty.

Greater wealth will improve consumer confidence and thus lead to greater spending.

Question 27

How does the distribution of income influence consumer spending?

Answer 27

Those on high incomes tend to save higher percentage of their income than those on low incomes and so a change in the distribution of money in the economy will affect the level of consumption. For example, if the money is distributed from the rich to the poor, consumption is likely to increase as the poor have a higher MPC.

Question 28

How do tastes and attitude influence consumer spending?

Answer 28

In today’s modern society, there is a strong materialistic drive that encourages people to have the newest and the best good/services spending can be very high, in some cases even above income.

More materialism = More consumption.

Question 29

Define investment

Answer 29

Investment is the addition of capital stock to the economy i.e. machines and factories used to produce other goods and services.

Question 30

Define Gross investment

Answer 30

Gross investment is the amount of investment carried out and ignores the level of depreciation.

Question 31

Define net investment

Answer 31

Net investment is the gross investment minus the value of depreciation.

Question 32

How does the rate of economic growth influence investment?

Answer 32

-If the economy is growing, there be higher levels of investment.

-This is because businesses would be more confident about their investments and the higher demand would lead to a higher return rate on the investment.

-Furthermore, a growing economy needs more investment in order to cope with the higher levels of demand.

Question 33

How do business expectations and confidence influence investment?

Answer 33

When businesses are confident about the future and expect future growth, investment will increase as they want to prepare for the future (the investment is likely to be profitable).

Question 34

How does the demand for exports influence investment?

Answer 34

If the world economy is booming, demand for exports is likely to increase and therefore firms’ investment is likely to increase to cope with this extra demand. This will have a knock-on effect and encourage other firms to increase their investment.

Question 35

How do interest rates influence investment?

Answer 35

High interest rates means that borrowing is more expensive, so a business needs to more confident of good profits in order to cover the extra costs of borrowing.

A rise in interest rates increases the opportunity cost of a business using retained profits as they are able to get higher interest payments than before.

Question 36

How does the government influence investment?

Answer 36

Governments can encourage investment by their own policy decisions. For example, they could offer tax breaks or grants to businesses to try and encourage them to invest.

Regulations also affects investment as a highly regulated economy tends to see less investment as regulation increases the cost and time take to invest, such as planning regulation.

Question 37

How do retained profits influence investment?

Answer 37

-Retained profits are the profits kept by a firm and not shared with shareholder or used to pay taxes.

-Many firms are unwilling to borrow money for investment in case the investment fails to make a profit and they are unable to pay it back.

-Therefore, if firms are making higher retained profits, investment is likely to increase as firms have more money available to invest.

Question 38

How does the trade cycle influence government expenditure?

Answer 38

Decisions over government expenditure may be in order to manage AD, and therefore regulate the trade cycle.

In a recession, the government may increase spending in order to increase demand to reduce unemployment. Also, government spending automatically rises during a recession as the government must spend more on unemployment benefits.

In contrast, during booms, the government may decrease spending to decrease demand and reduce inflation.

Question 39

How does the age distribution of the population influence government expenditure?

Answer 39

An ageing population leads to increase government expenditure on pensions and social care. In contrast, a young population leads to increase spending on education. Overall, the more dependents there are in an economy (the young and old), the higher government spending tends to be.

Question 40

How does fiscal policy influence government expenditure?

Answer 40

Fiscal policy is the decisions about government spending and taxes, it depends on the priorities of the government. For example, in a recession, government spending will increase as more needs to be spent of unemployment benefits.

Question 41

What is net trade?

Answer 41

Net trade is the total exports minus the total imports.

Question 42

How does real income influence net trade?

Answer 42

When real income in the UK is high, there tends to be increased imports as people demand more goods and services as the UK is unable to meet their needs. This will mean than net trade will decrease.

However, if an increase is real income is due to export-led growth then net trade will decrease.

Question 43

How do exchange rates influence net trade?

Answer 43

-A strong pound makes imports cheaper and exports dearer because it costs foreigners more to buy pounds with their local currency. As a result, imports will increase and exports will decrease so net trade will decrease.

However, this depends on the elasticity of imports and exports. If exports
are elastic, a rise in price will cause a large fall in demand so the value of exports will fall. If exports are price inelastic, a rise in price only leads to a small fall in the amount of exports so the value of exports will rise.

This is the same for imports.

Therefore, if both imports and exports and elastic, a rise in the value of the pound will lead to a fall in net trade.

Question 44

How does the degree protectionism influence net trade?

Answer 44

Protectionism is an attempt to prevent domestic producers suffering from competition abroad. Tariffs, quotas and technical barriers are introduced which makes it harder for producers from abroad to export their goods in the UK.

If there is high protectionism on UK exports in other countries, exports will decrease as it will be more difficult and expensive for UK firms to sell their goods to other countries.

If the UK imposes protectionist measures, other countries are likely to retaliate and therefore exports are likely to decrease.

Question 45

How does goods of a higher quality and design influence net trade?

(non-price)

Answer 45

If UK goods are of a higher quality and design, exports will be high as foreign demand for UK goods will increase and imports will decrease as people will buy the British goods instead of foreign goods. This means that net trade will increase.

Question 46

How do goods that are well-marketed influence net trade?

(non-price)

Answer 46

If UK goods are well marketed, people will have a stronger desire to buy British goods so exports will increase and imports will decrease, so net trade will increase. Furthermore, strong marketing will means that British exports are likely to be more inelastic, so if the prices of exports rise the value of exports will rise.

Question 47

How do prices influence net trade?

Answer 47

High price of UK goods mean that the goods are less competitive compared to international goods since people make decisions partly based on price. This means that the volume of exports will decrease and the volume of imports will increase. Therefore, net trade decreases.

This depends of PED, if PED is elastic, then higher prices will lead to a fall in net trade.