Theme 2 - aggregate demand

Question 1

Aggregate demand

Answer 1

Aggregate demand is the total level of spending within an economy over a given period of time

Question 2

The formula for aggregate demand

Answer 2

AD = C + I + G + (X - M)

Question 3

Why is the aggregate demand curve downward sloping

Answer 3

The aggregate demand curve show that as the price level increases, Real GDP decreases (national output)

Question 4

what is the Income effect

Answer 4

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.

Question 5

What is the substitution effect

Answer 5

If UK prices increased, then consumers will opt for cheaper alternatives as they can afford less

Question 6

What is the real-balance effect

Answer 6

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.

Question 7

What is the interest-rate effect

Answer 7

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.

Question 8

What causes a movement and a shift

Answer 8

A movement is caused by an increase/decrease in price and a shift is caused by another variable such as consumer confidence

Question 9

What is the definition for consumption

Answer 9

a spending on consumer goods and services over a given period of time

Question 10

What is the definition for disposable income

Answer 10

Money consumers have left to spend, after deductions such as taxations

Question 11

Formula for MPC

Answer 11

Change in consumption/change in income

Question 12

Formula for APC

Answer 12

total consumption/total income

Question 13

What is meant by marginal propensity to consume

Answer 13

How much a person saves and spends from every extra pound earned

Question 14

Why might a poorer person have a higher MPC than a richer person

Answer 14

Poorer people do not have enough disposable income to save and so majority of their income will be spent on basic necessities.

Question 15

Influences that will impact consumer spending

Answer 15

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.

Question 16

What is the Keynesian consumption function

Answer 16

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)

Question 17

What do Keynesian believe the government should do

Answer 17

Decrease income tax and increase income benefits

Question 18

What is the formula for the Keynesian consumption function

Answer 18

C = a +byd
a = autonomous income
b = marginal propensity to consume
yd = Disposable income

Question 19

What is the permanent income hypothesis

Answer 19

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

Question 20

What is the formula for Permanent income

Answer 20

C = Kyp
K = constant average and MPC
Yp = Permanent income

Question 21

What is the Life cycle hypothesis

Answer 21

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)

Question 22

What is the formula for Life cycle hypothesis

Answer 22

C = (w + Ry) / T
w = wealth
R = years until retirement
Y = income
T = remaining years of life

Question 23

What is investment

Answer 23

Expenditure by firms on additional capital stock such as machinery

Question 24

What factors increase the rate of investment

Answer 24

Lower capital good prices, technological advancements, Lower interest rates, increase rate of growth and animal spirits - consumer confidence.

Question 25

What is the accelerator effect

Answer 25

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).

Question 26

What is marginal efficiency of capital

Answer 26

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.

Question 27

What is meant by government spending

Answer 27

Government spending is how much the government spends on the welfare of the economy (goods and services) by central and local governments.

Question 28

Influences on government expenditure

Answer 28

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.

Question 29

Meaning of exports and imports

Answer 29

Exports is expenditure by foreigners on UK goods and services and imports is expenditure by the UK on foreign goods and services

Question 30

What influences net trade

Answer 30

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.

Question 31

The multiplier effect

Answer 31

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.

Question 32

What makes the multiplier effect stronger

Answer 32

A higher MPC, lower MPS, more confidence and spare capacity.

Question 33

What is spare capacity

Answer 33

This is when a business is not utilising its factors of production such as land, labour and capital

Question 34

What is the formula for multiplier effect

Answer 34

1/MPW or 1/1 - MPC

Question 35

Why is aggregate demand downward sloping

Answer 35

Keynes interest rate effect, Pigou’s wealth effect, Mundell - Flemings exchange rate effect ad micro summations.

Question 36

Keynes interest rate effect

Answer 36

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

Question 37

Pigou’s wealth effect

Answer 37

This is when price levels increase so every £1 someone earns is worth less and so people save more ( real - balance effect)

Question 38

Mundell - Flemings exchange rate effect

Answer 38

Price levels increasing increase imports and decreases exports causing a contraction in AD

Question 39

Micro summations

Answer 39

This is when each micro market is downward sloping so overall AD will be downward sloping.