LS3 - Aggregate Demand Flashcards
Aggregate demand
Total of all demands or expenditures in the economy at a given price over a period of time.
Measuring national expenditure/AD
- Consumption (C) - spending by households on goods and services
- Investment (I) - spending by firms on capital goods
- Government spending (G) - includes current spending on wages, includes speding by govt on investment goods such as new roads or schools
- Net exports (X - M) - imports do not contribute to national income, so it must be subtracted to show the money going out of a country, while exports is money coming into the country
AD = C + I + G + (X - M)
AD curve
Shows price level relationship with level of real expenditure
Price level - average level of prices
Real output - real expenditure and real income
AD curve plots level of expenditure where economy would be in eq position at each price level.
Why does the AD curve slope downwards?
Wealth effect - if price level increases, value of real wealth decreases, as they have to pay more to buy the same things. Consumption will decrease, as people will have less disposable income, causing a decrease in demand and a movement up the AD curve. Vice versa, demand increases, movement down AD curve
International trade effect - rising price level domestically make exports for foreign countries more expensive, so exports fall, but imports increase as they are cheaper, so net exports decreases, AD decreases, movement up the curve. Vice versa, net exports increase, AD increases, movement down the curve
Interest rate effects - if the price level increases, consumers will need more money to purchase goods, meaning they start to borrow money, leading to and increase in the demand for money, increasing interest rates,
if interest rates increase, it will become more expensive to borrow money, and consumption funded via borrowing will decrease, so there is an upward movement in the AD curve. Vice versa, price decreases, interest rates decrease, consumption increases, movement down AD curve
Consumption and AD…
Consumption is influenced by interest rates –> if prices rise, consumers will need more money to buy the same goods and services as before –> people will need to borrow money to increase funds
This will increase demand for borrowed funds, but if there is a fixed supply of money available for borrowing, prices of borrwed funds will increase - increase in interest rates – > fall in consumption
Wealth effect - rise in price level leads to real value of consumer’s wealth decreasing.
Decrease in consumer confidence - less consumption
Increase in household indebtedness - less consumption
Investment and AD…
Rise in interest rates –> less investment as it is less profitable
Improvements in technology –> more investment spending
Government spending and AD…
Determined by political decisions of the government
Net Trade and AD…
Higher UK price levels compared to international levels - imports increase, exports decrease
Higher income in country A means it will import more from country B, increasing B’s exports, and hence AD
