Macro 2.2 Flashcards
What is aggregate demand (AD)?
The total level of spending in the economy at any given price
AD is calculated as AD = C + I + G + (X - M), where C is consumption, I is investment, G is government spending, and (X - M) is net exports.
What are the components of aggregate demand?
- Consumption (C)
- Investment (I)
- Government spending (G)
- Net exports (X - M)
Consumption makes up about 60% of AD, investment about 15-20%, government spending around 18-20% of GDP, and net exports about 5%.
What does consumption refer to in the context of aggregate demand?
Consumer spending on goods and services
It is the largest component of aggregate demand.
How much of aggregate demand does investment account for?
About 15-20%
Most investment is by the private sector (about 75%).
What is government spending in terms of aggregate demand?
Spending by the government on providing goods and services
Includes wages and salaries of public sector workers and investment goods like new roads and schools.
What are transfer payments, and are they included in aggregate demand?
Payments such as pensions and jobseekers’ allowances; they are not included in AD
Transfer payments are just transfers of money from one group to another.
What does net exports represent in aggregate demand?
Exports minus imports
A negative figure indicates that imports are higher than exports.
What is the shape of the aggregate demand curve?
Downward sloping
It shows the relationship between price level and real GDP.
What is the income effect?
A rise in prices reduces real incomes, leading to a contraction in demand
People can afford to buy less when their real income decreases.
What is the substitution effect?
If prices in the UK rise, demand for British exports decreases while demand for cheaper imports increases
This leads to a decrease in net exports and a contraction in aggregate demand.
What is the real balance effect?
A rise in prices reduces the value of savings, leading to decreased spending
People feel less secure and may want to save more.
What is the interest rate effect?
Rising prices increase demand for money, leading to higher interest rates
Higher interest rates reduce borrowing and investment, causing a contraction in aggregate demand.
What causes movements along the AD curve?
Changes in prices due to inflation or deflation
Movements along the curve indicate changes in the quantity of AD at different price levels.
What causes shifts of the AD curve?
Changes in any other variable affecting aggregate demand
A shift to the right indicates an increase in AD, while a shift to the left indicates a decrease.
What is disposable income?
The money consumers have left to spend after taxes and state benefits
It is a key factor determining the level of consumption.
What is the marginal propensity to consume (MPC)?
The proportion of additional income that is spent on consumption
MPC is usually positive but less than 1 for most people.
What is the average propensity to consume (APC)?
The average amount spent on consumption out of total income
In an industrialized country, the APC is likely to be less than one.
What is the relationship between savings and consumption?
An increase in consumption decreases savings
Factors affecting consumption also affect savings in the opposite way.
What is the marginal propensity to save (MPS)?
The proportion of additional income that is saved
MPS = change in savings/change in income.
What factors influence consumer spending?
- Interest rates
- Consumer confidence
- Expectations regarding taxation and interest rates
- Wealth effects
- Distribution of income
High interest rates increase costs and reduce consumption.
What is the wealth effect?
A change in consumption following a change in wealth
Greater wealth leads to greater levels of consumption due to increased confidence.
What is the relationship between greater wealth and consumer spending?
Greater wealth improves consumer confidence, leading to greater spending.
How does the distribution of income affect consumption?
Those on high incomes tend to save a higher percentage of their income, affecting consumption levels.
What happens to consumption if money is moved from the rich to the poor?
Consumption is likely to increase as the poor have a higher marginal propensity to consume (MPC).
How do tastes and attitudes influence spending behavior?
A strong materialistic drive encourages people to spend, potentially even above their income.
Define investment in economic terms.
Investment is the addition of capital stock to the economy, such as machines and factories used to produce goods and services.
Differentiate between gross and net investment.
Gross investment ignores depreciation, while net investment is gross investment minus the value of depreciation.
Why is the distinction between net and gross investment important?
In the UK, depreciation accounts for about 75% of gross investment.
What effect does a growing economy have on investment?
Higher levels of investment occur as businesses are more confident and demand increases.
What are ‘animal spirits’ in the context of investment?
‘Animal spirits’ describe the confidence of businesses regarding future growth and profitability.
How does demand for exports influence investment?
Increased demand for exports leads to higher investment by exporting firms to meet extra demand.
What is the impact of high interest rates on investment?
High interest rates increase borrowing costs, making businesses more cautious about investments.
What does Keynes’ Marginal Efficiency of Capital (MEC) graph illustrate?
It shows how higher interest rates lead to a fall in investment due to required rates of return.
How can government policy influence investment?
Governments can encourage investment through tax breaks or grants.
What is the effect of access to credit on investment?
High-risk investments have lower access to credit, leading to decreased investment.
What are retained profits?
Retained profits are the profits kept by a firm and not distributed to shareholders.
How does technological change impact investment?
Improvements in technology can increase profitability and require businesses to invest to stay competitive.
What happens to investment levels when the cost of capital projects rises?
Higher costs increase risk, leading to lower levels of investment.
What role does government spending play in aggregate demand (AD)?
Government spending significantly impacts AD through expenditures on various sectors.
How does the trade cycle influence government expenditure?
Governments may adjust spending to manage AD and regulate the trade cycle, increasing spending in recessions.
What is fiscal policy?
Fiscal policy involves government decisions regarding spending and taxes based on priorities.
How does the age distribution of the population affect government spending?
An ageing population leads to increased spending on pensions and social care, while a young population increases education spending.
Define net trade.
Net trade is the total exports minus the total imports.
What effect does high real income have on net trade?
High real income tends to increase imports, potentially decreasing net trade.
How do exchange rates influence net trade balance?
A strong pound makes imports cheap and exports expensive, leading to decreased net trade.
What happens to imports when foreigners find it more expensive to buy pounds with their local currency?
Imports will increase and exports will decrease, leading to a decrease in net trade.
What is the effect of price elasticity on imports?
If imports are price elastic, a rise in price will cause a large fall in demand; if inelastic, a rise in price leads to a small fall in demand.
How does the price elasticity of demand (PED) affect exports?
If exports are inelastic, a rise in price results in a rise in value; if elastic, it causes a fall in value.
What is the outcome when both imports and exports are elastic?
A rise in the value of the pound will lead to a fall in net trade.
How does the state of the world economy influence UK exports?
If the UK’s main export country is doing well, UK exports are likely to rise, increasing net trade.
What factors determine the effect of the world economy on UK trade?
The countries doing well and the trade relationship the UK has with them.
Define protectionism.
An attempt to prevent domestic producers from suffering from competition abroad.
What are common methods of implementing protectionism?
- Tariffs
- Quotas
- Technical barriers
What happens to UK exports if there is high protectionism from other countries?
UK exports will decrease as it becomes harder for UK firms to sell their goods abroad.
What is the effect of high protectionism on imports into the UK?
Imports will decrease.
What is the potential consequence of the UK imposing protectionist measures?
Other countries are likely to retaliate, causing a decrease in UK exports.
How does free trade affect net trade in relation to aggregate demand (AD)?
Net trade will be a more significant part of AD, either positively or negatively.
Name two non-price factors that affect net trade.
- Quality and design
- Marketing
What is the impact of high quality and design of UK goods on trade?
Exports will be high and imports will decrease, increasing net trade.
How does effective marketing influence net trade?
Well-marketed UK goods increase exports and decrease imports, leading to increased net trade.
What is the relationship between high prices of UK goods and their competitiveness?
High prices make UK goods less competitive, leading to a decrease in exports and an increase in imports.
How does the inflation rate affect prices of UK goods?
If the UK inflation rate is higher than other countries, prices will rise faster.
What role does productivity play in determining prices?
Higher productivity leads to lower costs, resulting in lower prices.
How does price elasticity of demand (PED) influence net trade in response to changing prices?
If PED is elastic, higher prices will lead to a fall in net trade.
