Theme 2 - aggregate demand Flashcards
Aggregate demand
Aggregate demand is the total level of spending within an economy over a given period of time
The formula for aggregate demand
AD = C + I + G + (X - M)
Why is the aggregate demand curve downward sloping
The aggregate demand curve show that as the price level increases, Real GDP decreases (national output)
what is the Income effect
The income effect is when an increase is when price level increases, consumer incomes do not increase immediately with this so can afford to buy less then current rates of consumption.
What is the substitution effect
If UK prices increased, then consumers will opt for cheaper alternatives as they can afford less
What is the real-balance effect
This is when a rise in price means that people’s savings will be worth less therefore they will have to save more in order for it to have worth.
What is the interest-rate effect
This is when wages have to be increase as a result of inflation. This will increase interest rates as a result of higher demand for money therefore decreasing consumption and increasing savings.
What causes a movement and a shift
A movement is caused by an increase/decrease in price and a shift is caused by another variable such as consumer confidence
What is the definition for consumption
a spending on consumer goods and services over a given period of time
What is the definition for disposable income
Money consumers have left to spend, after deductions such as taxations
Formula for MPC
Change in consumption/change in income
Formula for APC
total consumption/total income
What is meant by marginal propensity to consume
How much a person saves and spends from every extra pound earned
Why might a poorer person have a higher MPC than a richer person
Poorer people do not have enough disposable income to save and so majority of their income will be spent on basic necessities.
Influences that will impact consumer spending
Increase in wealth, increase in disposable income, Decrease in interest rates, Decrease in income tax, The age of the population (it is rational for a younger person to spend more), more credit, increase in consumer confidence.
What is the Keynesian consumption function
The Keynesian consumption function say that at low incomes, people will spend a higher proportion of their money because they have less to save. (John Maynard Keynes)
What do Keynesian believe the government should do
Decrease income tax and increase income benefits
What is the formula for the Keynesian consumption function
C = a +byd a = autonomous income b = marginal propensity to consume yd = Disposable income
What is the permanent income hypothesis
This was a hypothesis made by Milton Friedman. This said that people consume based on their future predicted income. This means that if income tax fell, consumption would not increase as a result of people knowing that this is temporary and it will increase again. A persons assets determines their permanent income e.g wealth
What is the formula for Permanent income
C = Kyp K = constant average and MPC Yp = Permanent income
What is the Life cycle hypothesis
The life cycle hypothesis states that at low incomes, people have a higher MPC and at high incomes, people have a high MPS. This means that for students it is rational to borrow to fund education and so they spend more however, at around 40, income is peak so you save more in order to have the same rate of income during pension. (Ando Modigliani)
What is the formula for Life cycle hypothesis
C = (w + Ry) / T w = wealth R = years until retirement Y = income T = remaining years of life
What is investment
Expenditure by firms on additional capital stock such as machinery
What factors increase the rate of investment
Lower capital good prices, technological advancements, Lower interest rates, increase rate of growth and animal spirits - consumer confidence.
What is the accelerator effect
The accelerator effect means that when there is a rapid increase in the national income, this means there is a rapid increase in investment in order for firms to meet demand. This could be a result of an increase in consumer confidence ( Animal spirits).
What is marginal efficiency of capital
This means that firms will only invest in capital stock if the rate of return is higher then interest rates. For example if interest rates is 2% and ROR is 3% then firms will invest.
What is meant by government spending
Government spending is how much the government spends on the welfare of the economy (goods and services) by central and local governments.
Influences on government expenditure
The trade cycle: in a recession, governments increase spending to increase demand and decrease unemployment.
Fiscal policy: Things the government must spend their money on depending on priorities.
Demographics: ageing population leads to increased spending on social care and pension, younger population increases spending on education.
Meaning of exports and imports
Exports is expenditure by foreigners on UK goods and services and imports is expenditure by the UK on foreign goods and services
What influences net trade
Real-income increases imports, Exchange rates decreases imports increase, Protectionism on imports will cause a decrease in imports, State of global economy means if trade companies are doing well the this will increase AD.
The multiplier effect
The multiplier effect means that when there is an greater initial increase in an injection then there will be a greater final increase in AD. This is a positive multiplier effect. Vice versa is negative.
What makes the multiplier effect stronger
A higher MPC, lower MPS, more confidence and spare capacity.
What is spare capacity
This is when a business is not utilising its factors of production such as land, labour and capital
What is the formula for multiplier effect
1/MPW or 1/1 - MPC
Why is aggregate demand downward sloping
Keynes interest rate effect, Pigou’s wealth effect, Mundell - Flemings exchange rate effect ad micro summations.
Keynes interest rate effect
This is when price levels increase (inflation), this increases demand for borrowing due to people affording less. This then causes interest rates to increase causing a contraction in AD as consumption and investment decreases
Pigou’s wealth effect
This is when price levels increase so every £1 someone earns is worth less and so people save more ( real - balance effect)
Mundell - Flemings exchange rate effect
Price levels increasing increase imports and decreases exports causing a contraction in AD
Micro summations
This is when each micro market is downward sloping so overall AD will be downward sloping.
