Theme 2 - Aggregate Demand Flashcards
What is aggregate demand?
The total spending on a country’s goods and services at a given price level in a given time period
What is the formula for aggregate demand?
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)
What factors affect the net trade figure?
- Disposable incomes
- Domestic inflation
- Exchange rate
- Protectionism
- State of the world economy
Non-price factors:
- Branding
- Customer service
- Availability of substitutes
- Unique design / patent
What factors influence the extent to which the next export figure is impacted?
- 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
What factors influence consumption?
- Real disposable income
- Structure of the population
- Taxation
- Consumer confidence
- Household debt and future income expectations
- Interest rate
- Wealth
- Availability of credit
- Inflation
What is average propensity to consume?
The proportion of disposable income that is spent on consumption of goods and services.
How do you calculate APC?
APC = consumption/disposable income
What is marginal propensity to consume?
The proportion of a change in income which is spent
How do you calculate MPC?
change in consumption / change in income
How do you calculate average propensity to save?
saving/disposable income
What is wealth, and how does it affect consumption?
The value of assets
If wealth increases, consumption increases
What is consumer confidence and how does it affect consumption?
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
What factors influence consumer confidence?
- Job security
- State of the economy / recession
- Bonus / pay expectations
- Ease of obtaining credit
How do interest rates affect consumption?
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
How does the population structure affect consumption?
Young people and old people have a higher APC
How does taxation affect consumption?
- 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
How does household debt and future income expectations affect consumption?
- 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
How does the availability of credit affect consumption?
- 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
How does inflation affect consumption?
- 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
What factors affect how much someone can save?
- Interest rates
- Real disposable income
- Consumer confidence and expectations
- Population structure
- Saving schemes
- Range and quality of financial institutions
- Government policies
What is average propensity to save?
The proportion of disposable income saved
What is a target saver?
people who save with a particular target sum in mind
What is meant by dissave?
Spending more than your income
What is investment?
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
What are the factors that influence investment?
- Interest rates
- Rate of economic growth
- Business confidence
- Government influence
- Capacity utilisation
- Retained profit
- Access to credit
What is human capital?
Investment in education and training
Gross vs net investment
- 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
What is the accelerator theory?
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
How can investment be financed?
- Loans
- Retained profit
- Issue more shares
How do you calculate investment in a time period?
accelerator coefficient (change in real income during year 1)
Limitations of the accelerator effect
- 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
How does business confidence affect investment?
- 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
How does capacity utilization affect investment?
- 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
How does government influence affect investment?
- 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
How do interest rates affect investment?
- 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
What influences government spending?
Trade cycle
Fiscal Policy
Age distribution of the population
natural disasters
level of government intervention
political agenda
What is the trade cycle?
Boom, Slowdown, Recession, Recovery…
How does the trade cycle influence government spending?
- Decisions over expenditure may be made to manage AD, and therefore regulate the trade cycle
- If the economy is in recession, the government may increase spending to increase demand to reduce unemployment
- Spending rises automatically during recession as they have to spend more on benefits
- During booms, they may reduce spending to decrease demand and reduce inflation
How does fiscal policy influence government spending?
- Some gov, spending is fixed from year to year, e.g. schools and pensions, but gov.s can vary what they spend from year to year, and this is set out in their budget
- Fiscal policy is the decisions about government spending and taxes, and it will depend on the priorities of the government
- The level of government spending depends on what they lay out in their fiscal policy
How does age distribution influence government spending?
- An ageing population leads to increased expenditure on pensions, social care etc.
- A young population leads to increased spending on education
- The more dependents in an economy, the higher gov. spending tends to be
When are the types of fiscal policy used?
Expansionary final policy is used during recession, as it increases AD
Contractionary fiscal policy is used during high inflation as it decreases AD
What are the non-price factors which impact net trade?
Branding
Customer service
Availability of substitutes
Unique design/patent
What factors influence the net trade balance?
Real income
Exchange rates
State of world economy
Degree of protectionism
Prices
How does real income influence net trade?
- When real income is high, there tends to be increased imports as people demand more goods and services and the UK is unable to meet their needs, so net trade decreases
- However, if it is due to export-led growth, then net trade will increase
How does exchange rate influence net trade?
- Strong pound makes imports cheap and exports dear, as it costs foreigners more to buy pounds with their money
- Imports increase, and exports decrease, so net trade falls
- If imports are price elastic, a rise in price will cause a large fall in quantity demanded, and the value of imports will fall
- If imports are inelastic, a change in price will only cause a small fall in quantity demanded, so the value of imports will rise
- If imports and exports are both elastic, a rise in the value of the pound will cause a fall in the net export figure
How does the state of the world economy influence net trade?
- If the UK’s main export country is doing well, the UK exports are likely to rise, so net trade is likely to rise
- The effect is dependent on what countries are doing well, and the trade relationship that the UK has with them
How does protectionism influence net trade?
- Protectionism is an attempt to prevent domestic consumers suffering from competition abroad
- Tariffs, quotas, and technical barriers are introduced which make it harder for foreign producers to sell in the UK
- If there is high protectionism on UK goods in other countries, exports will decrease, as it is harder for UK firms to sell their goods abroad
- If there is high protectionism on goods coming into the UK, imports will fall
- If the UK imposes protectionist measures, other countries are likely to retaliate, and therefore exports are likely to decrease
- Free trade means net trade will be a more significant part of AD
How does price influence net trade?
- Higher prices of UK goods means that they are less competitive compared to international goods, as people make decisions based mostly on price
- This means the volume of exports will decrease and the volume of imports will increase
- The effect depends on PED
What goes on the axis of the AD curve?
X axis - Real GDP
Y axis - General Price Level
Change in price level causes movement along the curve
What are the reasons the AD curve slopes downwards?
- International trade effect
- Wealth effect
- Rate of interest
Why does the international trade effect cause the AD curve to slope downwards?
Domestic general price level rises
Makes domestic goods and services less competitive
Less quantity demanded domestically
Consumers buy more from abroad, value of imports increases
Net exports figure will fall
AD falls
Why does the interest effect cause the AD curve to slope downwards?
Price level increases, and more money is needed to buy the same things as before
People try to fund spending through borrowing
There is increased demand for borrowed funds, but only a limited supply that can be lent out from banks and building societies, so interest rate rises, increasing the cost of borrowing
Market interest rates rise to control the level of people who want to borrow
Consumption falls
Investment falls
AD falls
Why does the wealth effect cause the AD curve to slope downwards?
Price level rises
Interest rates rise
House prices fall as mortgage payments rise, so demand falls, consumers feel less wealth so less confident, and spending falls
Firms profits, and thus share prices and dividend payments fall
AD falls
When do shifts of the AD curve occur?
If there is a change in any of the AD variables, apart from price
How does the rate of economic growth influence investment?
In a growing economy, there will be higher levels of investment as businesses would be more confident about their investments and the higher demand would lead to a higher return rate on the investment.
A growing economy also needs more investment in order to cope with the higher levels of demand. If the same products and the same output is being produced each year, and no more is demanded, investment will stay the same as firms only have to replace old machines.
If the economy is growing firms will need to increase investment to match the level of demand and if it is shrinking, firms will not need to replace old machines so investment will fall
How do ‘animal spirits’ (business expectations and confidence) influence investment?
When businesses are confident about their future and expect future growth, investment will increase as they want to prepare for the future. If they are fearful of the future, then they will not invest money in new ideas or machinery. Keynes used the term ‘animal spirits’ to describe the feeling of managers and owners of firms on whether their investment would be profitable
How does demand for exports influence investment?
If the world economy is booming, demand for exports is likely to increase and therefore exporting firms’ investment is likely to increase to cope with this extra demand. This will have a knock-on effect and encourage other firms to increase their investment
How does access to credit influence investment?
Investment will be lower when an investment has a high risk attached to it, as it means there will be less access to credit and interest rates will be higher. In recessions, it is usually more difficult to access credit as risks are higher and banks become more risk aware, fearing firms will not be able to pay the money back.
What is capital?
Anything that helps you to produce goods and services
What is a trade surplus?
value of exports > value of imports ; causes a rise in aggregate demand
What is a trade deficit?
value of exports < value of imports ; fall in aggregate demand
