The components of Aggregate Demand Flashcards
Aggregate Demand is the Total Spending on goods and services
- Aggregate demand is the total demand, or the total spending in an economy over a given period of time
- made up of alll components that contribute in spend/demand in economy
- calculated using - AD = Consumption (C) + Investment (I) + Government spending (G) + (Exports(X) - Imports (M))
Consumption and Saving are affected by a number of factors
- Consumption is the total amount spend by households on goods and services. It doesnt include spending by firms.
- Increase in consumption will mean an increase in AD - reduction in consumption => reduction in AD
- Consumption is the largest component of AD - makes up about 65% of AD in the UK.
- This means that changes in the level of consumption will tend to have a big impact on AD.
- Savings made instead of consumption - income consumed or saved.
- when consumption is high, savings tend to be low, and vice versa.
Main factors affecting consumption and spending:
- INCOME - generally as disp income increases, consumption will rise. Rate of rise for consump is usually lower that rate of income rise as housholds tend to save.
- INTEREST RATES - higher interest rates => less consumer spending. Consumers save more to take advantage of higher rates and they’re less likely to borrow money or buy things on credit because its more expensive. Consumers may also have less money to spend if interest rates on existing loans and mortgages increase.
- CONSUMER CONFIDENCE - when consumers feel confident abt economy & own financial situ => spend more, save less. Affected by a no. of factors: e.g. recession consumers-> reluctant to spend because their confidence in the economy is low - worried abt losing their job. Reluctance can continue even after a recession.
- WEALTH EFFECTS - rise in household wealth e.g. due to sharp rises in share or house prices => rise in consumer spending, reduction in saving. Consumer condidence - if house prices rise faster than inflation => home owners more confident
- TAXES - direct tax increases => fall in consumer’s disposable income => spend less. Indirect taxes increases e.g. increase in VAT => increase in cost of spending -> reduce consumption. Reduction in taxes =>rise in consumer spending.
- UNEMPLOYMENT - when unemployment rises, consumers tend to spend less and save more. A fall in unemployment means more ppl have money to spend, and consumers are less worried about losing their jobs, increases consumer spending.
Dont confuse Saving and Investment
- investment and saving are different things
- savings tend to be made by households, investments tend to be made by firms
- Savings made by a household might be money put into a savings bank account each month. An investment made by a firm could be money paid to build a new office.
Investment is made by firms
Investment is money spent by firms on assets which they’ll use to produce goods and services - includes machinery, computers and offices.
- Gross investment includes all investment spending
- Net investment only includes investment tht increases productive capacity.
- E.g. if a firm has 3 old trucks but replaces these with 5 new trucks, the gross investment is ‘5 trucks’, but the net investment = 2 trucks.
1. firms invest with the intention of making profit in the future.
2. Investment makes up about 15% of AD in the UK
There are several factors which affect investment
- Risk: - Level of risk involved will affect amount of investment by firms
- If there’s a high risk that a firm won’t benefit from its investment then its unlikely that the firm will invest. E.g. when economic instability. - Government incentives and regulation: - government incentives such as subsidies or reductions in tax can affect the level of investment. E.g. reduction in corporation tax might encourage firms to invest, because they’ll have more funds available to do so.
- relaxing government regulations might reduce a firm’s costs and make it more likely to invest. - Interest rates and access to credit: - firms often borrow the money they want to invest.this means that when interest rates are high or firms unable to access credit, investment tends to be lower.
- higher interest rates would reduce how profitable an investment would be
- High interest rates will also mean there’s a greater opportunity cost of investing existing funds instead of putting them into a bank account with a high interest rate. - Technical advances: - firms need to invest in new technology to stay competitive. Investment will rise when significant technological advances are made
- Business confidence and ‘animal spirits’: - the more confident a business is in its ability to make profits, the more money its likely to invest.
- ‘business confidence’ depends partly on the general optimism or pessimism of the company’s managers. Keynes recognised that not all investment decisions are based purely on reason and rational thinking, and that human emotion, intuition, and gut instinct = important factors. He called these factors ‘animal spirits’.
Government spending doesnt include transfers of money
- government spending component of aggregate demand is the money spent by the government of public goods and services, e.g. education, health care, defence and so on.
- Only money that directly contributes to the output of the economy is included - this means that transfers of money such as benefits or pensions are not included.
- Government spending = large component of aggregate demand, so changes in government spending can have a big influence on aggregate demand.
Government spending doesnt have to be equal to revenue
- Government budget outlines a government’s planned spending and revenue for the next year. Governments will usually have either a budget deficit or a budget surplus.
- If gvernment spending is greater than its revenue, there will be a budget deficit.
- If government spending is less than its revenue, there will be a budget surplus - Governments use fiscal policy to alter their spending and taxation to influence AD
- if AD is low + economic growth is slow or even negative => government may overspend in order to increase AD and boost economic growth.
- If AD is high and the economy is experiencing a boom, a government might increase taxes and spend less to try to reduce aggregate demand and slow down economic growth. - An imbalance in the budget will affect circular flow of income - budget surplus = overall withdrawal from circular flow, budget deficit = overall injection into circular flow.
- imbalance in budget deficit is fine in the short run, but in long run governments will try to balance out any surpluses and deficits. Long-term surplus - may harm economic growth by choosing not to spend, or by keeping taxes too high. A long-term deficit is likely to mean a country has a large national debt.
- Sometimes governments will balance the budget so that government spending will be equal to revenue. Should have little effect on AD.
An Export from one country is Always an Import to another
- Exports = goods and services that are produced in one country, then sold in another. Imports are the opposite - they’re goods and services that are brought into a country after being produced elsewhere.
- Exports are an inflow of money to a country, and imports are an outflow - exports = injection into circ flow and imports withdrawal
- exports minus imports (X-M) make up the net exports compoennt of aggregate demand
- If the amount spent on imports exceeds the amount recieved from exports, net exports will be a negative number
Factors that affect net exports:
1. the exchange rate
EXCHANGE RATE
change in the value of the currency will affect net exports in short and long run:
1. In long run - if value of a currency increases, imports become relatively cheaper and exports become relatively more expensive for foreigners. As a result, demand for imports (M) rises and demand for exports (X-M) in the long run and reduce aggregate demand, but a weak currency will have the opposite effect and improve net exports.
2. In the short run - demand for imports and exports tends to be quite price inelastic. For example, some goods don’t have close substitutes, e.g. oil, whileothers might have substitutes, but there’s a time lage before countries switch to them - in short run AD wont change much. This means that intially when the value of a currency increases, net exports will actually improve because the overall value of exports increases and overal value of imports decreases.
Factors that affect net exports:
2. Changes int he state of the world economy
- The higher a country’s real income, the more it tends to import. So net exports fall as real income rises.
- The state of the world economy also affects exports and imports. For example, the USA exports lots of goods to Canada. If Canada goes through a period of low growth then exports from the USA to Canada will decrease. Assuming imports are unaffected, this means a worsening in the USA’s net exports. Similarly, if Canada experiences high growth rates, exports from the USA are likely to increase - improving net exports.
Factors that affect net exports:
3. Degree of protectionism
In the short run, tariffs and quotas can increase net exports by reducing imports. However, industries that are protected from international competition have few incentives to become more efficient, so will often export less in the long run. Also, in the long run, other countries may retaliate by introducing their own tariffs and quotas.
Factors that affect net exports:
4. Non-price factors
These include things such as quality of goods. For example, advancements in technology in a country that lead to the production of higher quality goods would likely to cause an increase in exports from that country, because people are willing to pay more for something if it’s really food. This would mean an improvement in net exports.
Net exports tend to make up a small percentage of aggregate demand, so changes in net exports have a minor impact on AD
