The characteristics of AD Flashcards
What is aggregate demand?
Refers to the total planned spending on goods and services in the economy at each price level.
What are the 5 main sources of demand (or spending) in the economy / what are the components of aggregate demand?
1) Household spending (C).
2) Investment spending (by firms) (I).
3) Government spending (G).
4) Export spending (by foreign consumers and firms on UK goods) (X).
5) Import spending (but we deduct this as this is spending by consumers and firms which leave the economy) (M).
How to calculate total aggregate demand?
C + I + G + ( X - M ) = AD
What does the AD curve show?
1) The Y- axis shows the average level in the economy and is labelled as price level. The X - axis is labelled as Real GDP and measures the different levels of income spending and output in an economy.
3) The AD curve is sloped downwards this shows an invers relationship between the average price level and income, spending and output in the economy.
4) The point at the price level axis is labelled as P and shows the current equilibrium price of Y. The point at the real GDP axis is labelled Y and it shows the current level of output, income and spending in the economy at price level P. Income and output should be the same.
Why does the government calculate aggregate demand?
The government needs to know what is happening to total spending in the economy so that it can control it.
How might the government try and control aggregate demand?
1) The government may try to increase total spending ( if there is too much spare capacity and too many unemployed resources because there is an opportunity cost of having idle resources an economy.
2) May want to reduce aggregate demand if total spending is too much for the economy and businesses don’t have the capacity to meet demand.
What is the relationship between price level and aggregate demand?
As price level increases aggregate demand decreases.
What causes a movement along the AD curve?
Change in price level. An increase in average price level reduces AD. A decrease in average price level increases AD.
What are the 3 reasons for the slope of the AD curve?
1) The real balance effect.
2 a) The trade effect (imports).
2 b) The trade effect (exports)
3) The interest rate effect.
Why does the real balance effect effect the slope of the curve?
If prices level rises from P to P1, then people have to buy less goods and services assuming they have the same level of income (ceteris paribus). Therefore, the output of goods and services bought and sold in the UK falls from Y to Y1.
Why does the trade effects (imports ) have an effect on the slope of the curve?
The AD curve shows prices of goods made in the UK. If the prices of goods made in the UK. If the prices of goods made in the UK increase ( and goods made in other countries stay at the same price), then we will buy more imports. There is a bigger leakage from the UK economy which reduces output from Y to Y1.
Why does the trade effect (exports) have an impact on the slope of the curve?
If the prices of goods made in the UK increases (from P to P1), UK exports become less internationally competitive. Foreign firms buy fewer UK goods, less money is injected into the UK economy which reduces output from Y to Y1.
Why does the interest rate effect have an impact on the slope of the curve?
If prices increase (from P to P1) this means that inflation has increased. The government will increase interest rates to reduce inflation. Increasing interest rates reduces consumers’ to disposable income so they spend less.
Which factors can cause a shift in the AD curve?
Any factor which effects C, I, G, X or M.
What effect does consumption ( C ) have on the AD curve?
AD will increase and shift to the right if consumption increases.
What effect does investments (I) have on the AD curve?
AD will increase and shift to the right if investments increase.
What effect does government spending (G) on the AD curve?
AD will increase and shift to the right if government spending increases.
What effect does exports - imports (X-M) have on the AD curve?
AD increases and shifts out to the right if (X-M) increases.
What may cause consumption to increase?
1) Reduction in income taxes.
2) Increase in benefits.
3) Reduction in interest rates.
4) Increase in wealth.
5) Increase in consumer confidence.
What may cause an increase government spending?
1) Policies to spend more on defence, education, road building, health care, housing, etc.
2) Ageing population.
3) Rise in pollution levels.
What may cause an increase in investment?
1) Increased business confidence.
2) A fall in interests rates.
3) Advances in new technology.
4) Reduction in corporation tax.
What may cause an increase in net exports?
1) Fall in £ exchange rates.
2) Rise in income in other countries.
3) Better quality manufacturing in the UK.
What are the benefits of consumption?
1) Consumer spending is the biggest of component of AD so a small increase will boost the economy.
2) Increasing consumer spending can provide a quick boost to the economy.
3) An increase in consumer spending will lead to higher business profits.
4) An increase in consumer spending will lead to an increase in government revenue due to an increase in VAT receipts.
What are the benefits of investments?
1) The creation of new capital equipment and assets provides a long term boost to the economy.
2) New machinery and equipment may improve the quality or goods and services.
3) New machinery may result in cheaper goods and services.
What are the benefits of government spending?
1) Higher government spending can reduce inequality by improving services such as healthcare and education.
2) May be a quick way to boost the economy if government increases the pay of public sector workers.
3) Does not depend on any other variable to increase.
What are the benefits of net trade?
1) Only component which leads to an injection of new money into the economy.
2) Doesn’t depend on domestic demand.
3) Will increase investment as businesses make higher profits.
4) Helps improve international relations.
What are the draw backs of consumption?
1) Spending on consumer goods provides no lasting benefit to the economy.
2) Imports will often increase as UK consumers have a higher propensity to import.
3) Higher consumer spending could lead to a higher consumption of demerit goods such as fast food, alcohol and drugs.
What are the draw backs of investment?
1) The time between planning and outcome.
2) Smallest component of AD so has smallest impact on the economy.
3) Investment in automation may lead to increase in unemployment.
4) Usually depends on an increase in consumption.
What are the drawbacks of government spending?
1) Will lead to higher public sector debt or higher taxes in the future.
2) Government spending is not always effective (e.g. money wasted on bureaucracy in the NHS)
3) Higher government spending (e.g. on benefits or subsidies) may lead to dependency.
What are the drawbacks of net trade?
1) Depends on growth of foreign economies.
2) Depends on other factors such as the value of the £, relations with other countries, protectionism etc.
3) May increase pollution due to higher transportation.
4) May be difficult to achieve due to barriers to international trade e.g. cultural, language, legal etc.
How important are the components of AD to AD?
1) 65% of AD is made up by consumption.
2) 35% of AD is made up by imports.
3) 32% of AD is made up by exports.
4) 20% of AD is made up by government spending.
5) 17% of AD is made up by investments.
