M 2.2 Aggregate demand Flashcards
What is aggregate demand?
total planned spending on real output produced in an economy
Formula for Ad?
AD = C + I + G + X - I
What are the five componants of aggregate demand?
- consumption
- investment
- government spending
- exports of goods and services
- imports of goods and services
When does the AD curve shift upwards?
a rise in the price level causes a contraction of AD
What does the AD curve fall?
A fall in the price level causes an expansion of AD
Why does the AD curve slope downwards?
- falling real incomes
- balance of trade
- interest rate effect
How do falling real incomes cause a downward sloping AD curve?
- as price level rises the real value of income falls and consumers are less likely to buy what they want or need (real balance effect)
How does balance of trade cause a sloping AD curve?
- persistant rise in the price level of Country X could make foreign produced goods and services cheaper causing a fall in exports and a rise in imports
How does the interest rate effect cuase a sloping downward AD curve?
- if price level rises, this causes inflation and an increase in demand for money and a possible rise in interest rates on loans which deflationary effect oon consumer and business demand
What will an outward shift in AD curve cause?
- will raise national output at all price levels
What will an inward shift in AD curve cause?
-will reduce national output at all price levels
What will cause a fall in AD?
- cut in government spending
- higher interest rates
- decline in household wealth
- increase in house prices
- fall in exports
What will cause an increase in AD?
- expansion of supply of credit
- lower interest rates
- depreciation of exchange rate
- cuts in direct and indirect taxes
What is aggregate consumption?
spending by all the households in the economy on the consumer goods and services
What are the main sources of consumer incomes?
wages, savings, return from savings, pensions and benefits
What are the 8 factors determining consumption?
- interest rate
- current level of income
- expected future income
- wealth
- levels of personal debt
- consumer confidence
- distribution of income
- expectation of future inflation
How does interest rate determine consumption?
- IR is the reward to savers for sacrificing current consumption. higher the interest rate the higher the reward. saving will increase as interest rate rises and level of consumption will fall
How does current level of income determine consumption?
as disposable income rises absolute consumption rises but consumption falls as a fraction of total income while fraction saved increases.
How does wealth determine consumption?
- increase in house prices and shires cause homeowners and shareholders to consume more and save less partly because the wealth increase does their saving for them
How does expected future income effect consumption?
- people plan savings and spending with a long term view of expected lifetime income.
How do levels of personal debt effect consumption?
if individuals have low levels of personal debt they will normally consume more as less disposable income is is diverted to repayments
How does consumer confidence effect consumption?
- when consumer optimism increases households generally spend more and save less. often linked to employment prospects or job security
how does distribution of income effect consumption
- rich people save a greater proportion of income then poor people, redistribution of income from rich to poor therfore increases consumption and reduces saving
When does saving occur?
when people decide to postpone their consumption until a future time
What is saving?
household disposable income that is not spent
What does a high savings ratio do?
lowers consumption and aggregate demand
What are the 8 factors affecting household saving?
- real interest rate
- price expectations
- availability of credut
- unemployment / job security
- consumer confidence
- taxation of savings
- trust in savings institutions
- need to pay back debt
What are the three macroeconomic reasons for saving?
- business survival
- funding investment
- buffer for consumers
Why is business survival important for saving?
- corporate savings provide a cushion during a recession
- business savings can be used as finance for takeovers and for capital investment projects
Why us funding investment important for saving?
- banks need deposits from which they can lend
- savings lflow into pension funds - these can be reinvested into stock markets providing investment funds
Why is a buffer for consumers important to savings?
- savings can smooth consumption during tough time
- allow people to reduce debts
- key source of retirement income
What does the personal savings ratio measure?
the actual savin of the personal secotr as a ratio of total personal disposable income
what is disposable income?
amount of money that households have available for spending and saving after income taxes have been acounted for
Give formula for personal savings ratio?
actual personal savings / personal disposable income
What is investment?
when people invest shares, bonds, properties or antiques
What does imvestment in economic theory mean?
planned demand for capital goods which include both physical capital and human cpaital
What type of concept is investment?
flow concept
What type of concept is capital stock?
stock concept
Differance between investment flow and national capital stock?
investment flow is measured over a period whereas natianal capital stock is measured at any particular time
What are the two parts to gross investment?
- replacement investment/ capital depreciation: maintain the size of the existing stock by replacing worn out capital
- net investment: adds to capital stock
What are the two types of investment in physical capital goods?
- Investment in fixed capital (new factories, social capital, roads)
- inventory investment in stocks of raw material, semi finished goods and finished goods
Differance between savings and investment?
- spending is income not spent on investment
- investment is spending by firms on capital goods such as machines and equipment
Name 7 factors effecting investment?
- expected future revenue
- expected future COP
- expected future profit
- prices of capital and labour
- nature of progress
- supply of investment funds
- government policies
How do expected future profits affect investment ?
- attributable to new investment project
How do future COP effect investment?
affected by interest rate and future maintenance costs
How do future profits effect investment?
- make investment if prospect of profit is positve
How do prices of labour and capital affect investment?
when price of capital rises, firms would substitute labour for capital and adopt more labour intensive methods of production , so investment falls
How does the nature of technical progress effect investment
- sudden burst of technical progress may cause firms to replace capital goods with machinary as its quicker
What does accelerator refer to?
a change in investment is induced by a change in growth rate of national income or aggregate demand
What does the accelerator effect stae?
investment levels are related the rate of change of GDP
What is the assumption of the accelerator theory?
firms wish to keep the capital - output ratio fixed
Explain accelerator theory?
- if firms see GDP and AD rising, they will use existing capacity and capital and labour force work harder to meed demand
- firm will eventually reach full capacity and will invest in capital equipment to meet future anticipated demand
What is the consequence of the accelerator effect?
investment in capital goods is a more volatile componant of aggregate demand then consumption. increase in rate of economic growth will cause larger increase in level of investment
If growth rate of output accelerates what happens?
investment increases
When will the accelerator effect be high?
- rate of change of consumer income and spending is strongly positve
- amount of spare productive capacity for businesses is low
- available supply of investment funds is high
4 macroeconomic advantages of a higher level of investment
-
- injection into circular flow of income
- new capital can boost productivity and creates additional capacity to supply
- creates extra demand in investment goods industries and can lead to strong multiplier effects on level of GDP
- will boost countries competativeness and therefore improve trade balance
What is government spending?
spending on state-provied goods and services including public goods and merit goods
How can the government finance spending?
tax revenue and borrowing
What is the amount the government borrows a year called?
budget deficit
How is the net trade balance measured?
value of exported goods and services - value of imported products
Factors effecting net export?
- UK productivity ( if more productive then more competative)
- exchange rates ( strong pound makes exports less competative)
- economic growth in other countries ( in key export markets)
- extent of free trade ( as trade broadens, new export opportunity)
What is the multiplier effect?
a change in one of the componants of AD can lead to a multiplied final change in the equilibrium level of GDP and national income
Equation for the multiplier?
change in initial injection / change in in real national income
what are the factors effecting the multiplier effect?
- interest rates (high interest, consumption may not rise significantly)
- tax rates ( tax is high, spending + consumption is low)
- imports
- spare capacity
WHat is the UK national debt ? define
the total amount of money the British government owes to the private sector and other purchasers of UK gilts
Explain the process of the mulitplier effect?
- new house builidng project injects 200million of extra demand and output into economy
- many businesses benefit directly including building supply industries and architects
- constructing new houses generates a new flow of factor incomes - including wages and profits
- if the extra income stays inside circulr flow the multiplier effect is likely to be strong and the resultant impact on GDP is large
What is the negative multiplier?
multiplier effect happening in reverse, a withdrawal from the economy
What will lead to a negtive multiplier and a fall in GDP?
cuts in spending and increases in taxes
What does the size of the multiplier depend on?
the marginal propensity to consume
IF an individual has a high MPC what is the effect?
higher value of multiplier
IF a individual has a higher MPS what will the multiplier be?
low
What is the marginal propensity to consume?
the change in consumer spending arising from a change in disposable income
Calculation for MPC?
change in consumption / change in disposable income
What is the formula for average propensity to consume?
consumption / income
What four factors determine MPC?
- income levels ( higher income, higher MPC)
- nature of income change (if people get a bonus, more likely to save, however if they get a pay rise they will have higher consumption)
- interest rates ( high interest rate encourages saving, low consumption)
- consumer confidence (high confidence, high consumption)
