Theme 2 - Aggregate Demand

Question 1

What is aggregate demand?

Answer 1

The total spending on a country’s goods and services at a given price level in a given time period

Question 2

What is the formula for aggregate demand?

Answer 2

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

C=consumer spending (consumption)
I = investment (addition of capital stock to the economy)
G = government spending
( X - M ) = net trade (exports minus imports)

Question 3

What factors affect the net trade figure?

Answer 3

• Disposable incomes
• Domestic inflation
• Exchange rate
• Protectionism
• State of the world economy

Non-price factors:
- Branding
- Customer service
- Availability of substitutes
- Unique design / patent

Question 4

What factors influence the extent to which the next export figure is impacted?

Answer 4

• Relative price level of exports/imports
• Quality of imports/exports
• Availability of substitutes
• Time frame
  -PED
• Marginal propensity to import (the change in spending on imports resulting from a change in household income)
• YED

Question 5

What factors influence consumption?

Answer 5

• Real disposable income
• Structure of the population
• Taxation
• Consumer confidence
• Household debt and future income expectations
• Interest rate
• Wealth
• Availability of credit
• Inflation

Question 6

What is average propensity to consume?

Answer 6

The proportion of disposable income that is spent on consumption of goods and services.

Question 7

How do you calculate APC?

Answer 7

APC = consumption/disposable income

Question 8

What is marginal propensity to consume?

Answer 8

The proportion of a change in income which is spent

Question 9

How do you calculate MPC?

Answer 9

change in consumption / change in income

Question 10

How do you calculate average propensity to save?

Answer 10

saving/disposable income

Question 11

What is wealth, and how does it affect consumption?

Answer 11

The value of assets
If wealth increases, consumption increases

Question 12

What is consumer confidence and how does it affect consumption?

Answer 12

Consumer confidence indicates how consumers feel about the state of the economy and will determine the willingness to spend.
If consumer confidence is high, consumption will be higher

Question 13

What factors influence consumer confidence?

Answer 13

• Job security
• State of the economy / recession
• Bonus / pay expectations
• Ease of obtaining credit

Question 14

How do interest rates affect consumption?

Answer 14

Interest rates are the cost of borrowing and the reward for saving
- High interest rates mean consumer prefer to save rather than spend, so consumption will fall
- Spending financed by credit will fall as high interest rates mean consumers have more to pay back
- mortgage repayments go up, sp require a higher proportion go inform, so consumption of other goods will fall

Question 15

How does the population structure affect consumption?

Answer 15

Young people and old people have a higher APC

Question 16

How does taxation affect consumption?

Answer 16

• Increases in direct taxation will decrease disposable income, so consumption will fall
• An increase in the basic rate of income tax would have a bigger impact than an increase in the upper bands

Question 17

How does household debt and future income expectations affect consumption?

Answer 17

• In the short run, increased household debt will increase consumption, as increased debt means households are spending more
• In the long run, it will decrease consumption as households save ti pay off the debt
• If consumers have poor expectations about future incomes, consumers will focus on paying off existing debts

Question 18

How does the availability of credit affect consumption?

Answer 18

• If it isn’t easily available, fewer people will borrow to spend and consumption will decrease
• This was an issue in the 2008/9 financial crisis

Question 19

How does inflation affect consumption?

Answer 19

• High inflation levels cause consumption to fall as the real clay of consumer’s disposable income falls
• Some people may increase consumption before prices rise more

Question 20

What factors affect how much someone can save?

Answer 20

• Interest rates
• Real disposable income
• Consumer confidence and expectations
• Population structure
• Saving schemes
• Range and quality of financial institutions
• Government policies

Question 21

What is average propensity to save?

Answer 21

The proportion of disposable income saved

Question 22

What is a target saver?

Answer 22

people who save with a particular target sum in mind

Question 23

What is meant by dissave?

Answer 23

Spending more than your income

Question 24

What is investment?

Answer 24

Spending on capital goods so that a firm can increase its output in the future. Investment is important as it can increase output in the future

Question 25

What are the factors that influence investment?

Answer 25

• Interest rates
• Rate of economic growth
• Business confidence
• Government influence
• Capacity utilisation
• Retained profit
• Access to credit

Question 26

What is human capital?

Answer 26

Investment in education and training

Question 27

Gross vs net investment

Answer 27

• Gross investment measures investment before depreciation (value of capital stock that has been used up / worn out)
• Net investment is equal to gross investment less the value of depreciation
• Depreciation is also called capital consumption
• Economic growth requires positive net investment

Question 28

What is the accelerator theory?

Answer 28

Increase in consumer demand
Firms get close to full capacity
Firms invest to meet rising demand

The accelerator theory suggests that the level of investment in an economy is related to changes in output or income

Question 29

How can investment be financed?

Answer 29

• Loans
• Retained profit
• Issue more shares

Question 30

How do you calculate investment in a time period?

Answer 30

accelerator coefficient (change in real income during year 1)

Question 31

Limitations of the accelerator effect

Answer 31

• Firms may not invest as it takes time to reach maximum capacity
• High demand is not guaranteed, so firms may not invest
• Investment is affected by factors, such as investor confidence and the ‘animal spirits’ of firms
• Depends whether firms are optimistic about their industry
• Firms won’t respond to every minor change in demand

Question 32

How does business confidence affect investment?

Answer 32

• If firms expect sales to increase, then they are more likely to invest in capital equipment. Business confidence is normally high during a boom, and low during a recession
• Animal spirits is a term used to describe the changing moods of managers and owners

Question 33

How does capacity utilization affect investment?

Answer 33

• Capacity utilisation is the extent to which firms are utilising their existing production potential / capital goods
• capacity utilisation = actual output / max output x100
• If capacity is fully utilised, there will be more investment as more capital is needed to increase output

Question 34

How does government influence affect investment?

Answer 34

• High levels of corporation tax will decrease profits, so investment will fall
• Government policies to guarantee loans to firms will increase firms ability to invest, so investment will increase
• Government legislations, such as planning regulations, may make it harder for firms to invest, so investment will fall
• Offsetting investment sums against corporation tax will decrease firms’ costs, meaning they can invest more

Question 35

How do interest rates affect investment?

Answer 35

• Interest rates are the cost of borrowing and the reward for saving
• A rise in interest rates will decrease investment, as firms will borrow less to spend on investment
• If there is a high return on investment, producers will choose to invest because it will bring higher profits in the long term
• If the opportunity cost of not investing is bigger than the opportunity cost of investing, then investment will increase