Macroeconomics Aggregate Demand Theme 2 Flashcards
Aggregate Demand definition
Total demand for goods are services in the economy
4 Main components of aggregate demand
Consumption (C)
Investment (I)
Government Spending (G)
Net Exports (X-M)
Reasons why aggregate demand curve slopes downwards against real gdp and price levels
The real balance effect: An increase in the average price level reduces the purchasing power of households, businesses, government and the foreign sector, so reducing the quantity of real output demanded.
The international competitiveness argument: at higher average prices, an economy is less likely to export as they are less competitive and are more likely to export, this decreases the X component and increases the M component of AD.
Interest rate arguments: at higher average prices, the interest rate is likely to be higher, meaning businesses will invest (I) less and consumers will consume (C) less too
What is a movement along the aggregate demand curve caused by
Caused by a change in price level ad is either called an expansion or contraction
What causes a shift in AD
Caused by a change un the components of AD, such as consumption, investment, government spending and net exports.
Definition of consumption
The total amount households spend on goods and services over a period of time
Factors influencing consumption (no explanation)
Consumer income
Changes in income taxation
Consumer confidence
Availability of credit
Interest rates
Wealth effect
How does consumer income affect consumption and therefore AD
If consumers have more income to spend they are able to consume more goods and services boosting AD
How does changing in income taxation affect consumption and therefore AD
Lower income taxation means workers will have more disposable income and therefore more opportunity to spend on goods and services
How does consumer confidence affect consumption and therefore AD
If consumers are more confident they will be more willing to spend their income rather than undertaking precautionary saving
How do wealth effects affect consumption and therefore AD
If consumers have greater wealth then consumers have more confidence which allows greater consumption. Consumers could also sell their assets to fund greater consumer spending.
How do interest rates affect consumption and therefore AD
If interest rates fall then this should encourage consumption as there is less incentive to save, more incentive to borrow and homeowners on variable mortgage will have less interest payments.
How does availability of credit affect consumption and therefore AD
If credit becomes more available for consumers then consumers will be able to borrow more easily to finance spending
Defintion of investment
Spending on capital goods which can be used to create products to sell i.e. increasing the capital stock of the economy
Gross investment meaning
Spending on capital goods, before depreciation is taken into account
Net investment meaning
Spending on capital goods, after depreciation is taken into account
Relationship between gross and net investment
Gross investment - depreciation = net investment
What is meant by capital depreciation
Some investment is needed each year just to replace technology obsolete or worn out plant and machinery
Factors influencing investment
The rate of economic growth
Keynes animal spirit
Interest rates
Business expectations and confidence
Access to credit
Government subsidies
Corporation tax
Demand for exports
How does the rate of economic growth affect investment and therefore AD
A high level of economic growth should mean that employment is high. This means there is more incentive to invest in capital goods as businesses are more confident of getting a return on their investment, as consumers are likely to consumer more goods and services as they are employed and earning income.
How does business expectations and confidence affect investment and therefore AD
If businesses have high levels of business confidence and expectations they are more likely to invest, such as when the economy is growing and consumers are spending. Therefore, businesses can invest as they are more likely to make a return on this investment as there is perceived to be lower risk of expansion.
How does Keynes’ and animal spirits affect investment and therefore AD
Often the crucial deciding factor will be expectations about the future performance of the economy. When in general business exceptions are optimistic, many investors take risks which they would not take if expectations were gloomy, once they see others doing this they become more likely themselves to take risks due to a herd instinct.
How does demand for exports affect investments and therefore AD
Higher demand for exports, the more incentive there is to invest and expand the business by purchasing capital goods to maximise profits which would allow more exports to be produced at possibly lower costs or highly quality.
Moreover, when demand for exports is high, firms should haver high profits with which to invest and expand their business
How does interest rates affect investment and therefore AD
Interest rates can encourage investment if they are low as this makes financing borrowing cheaper and gives less incentive to save rather than invest.
It also boosts consumer spending and so therefore business confidence and investment should also increase.
How does access to credit affect investment and therefore AD
If banks are willing to lend then firms will have the finances to invest in capital goods.
How does government subsidies affect investment and therefore AD
Government subsidies encourage production as they are a source of finance that can be used by firms to invest in capital goods
How would cooperation tax affect investment and therefore AD
Corporation tax is a tax on business profits, if corporation tax is lowered, then there is more incentive to invest as a smaller amount of the resulting profit will be taken in tax.
Moreover, lower corporation tax also gives businesses more profits after tax in order to finance purchasing new capital goods.
What are the two main influences on government spending
Fiscal Policy
The Trade Cycle
What is fiscal policy
The government may decide to change the level of spending in the economy when they change fiscal policy. This is known as discretionary fiscal policy
How does fiscal policy affect AD
Austerity to reduce the government budget would lead to a reduction in AD, but increased government spending would boost economic growth and AD
What is the trade cycle
A trade cycle refers to fluctuations in economic activities specially in employment
How does the trade cycle affect AD (example)
During a recession more workers will be made unemployed so government will spend more on unemployment benefits boost AD slight and reduce fall of GDP
During a boom the opposite will happen
What are net exports
The value of exports minus the value of imports (X-M)
What determines the exchange rate
Supply and Demand
Impact on exchange rate changes
- SPICED Stronger Pound Imports Cheaper Exports Dearer - This would worsen the Uk’s net export position
- WPIDEC Weaker Pound Imports Dearer Exports Cheaper - Improve the UK’s net export position
How does UK incomes affect next exports and therefore AD
- As imports tend to be normal goods as income rises the imports tend to increase too as the UK have a high marginal propensity to import. This will mean a reduction in net exports.
How does UK inflation affect net exports and therefore AD
If the UK is experiencing high rates of inflation this could increase the costs for UK firms and make them less internationally competitive reducing the demand for UK exports as well as causing UK to switch to buying more competitive imports from abroad
How does the state of the world economy affect net exports and therefore AD
If UK export markets see their economic growth rates fall, then this will reduce UK exports prospects and decrease net exports as foreign consumers feel less confident.
What is protectionism
Protectionism are measures that reduce free trade such as tariffs (tax on imports) and quotas (limit on imports).
How does the degree of protectionism affect net exports and therefore AD
If the EU increase protectionism, then this will reduce imports into the UK as they either are less price competitive or there is a limit to the number of imports
Moreover, if UK export markets reduce protectionism on UK products then this allows UK to export abroad
How do non-price factors affect net exports and therefore AD
For some products foreign customers may buy UK exports based on non price factors such as quality and design rather than price. An improvement in non-price factors will boost UK exports and therefore net exports
Factors influencing net exports (6)
- Exchange rate
- UK income
- Uk inflation
- Economic state of the world
- Degree of protectionism
- Non-price factors
Limits to greater export prospects (2)
Time to switch - in the short term consumers and companies may be stuck in contracts
Lack of UK manufacturing capacity - If UK does not have the capacity to export effectively they cannot take advantage of greater export opportunities
