Theme 2 - Aggregate Demand

Question 1

What is aggregate demand?

Answer 1

Total amount of spending on goods and services produced in an economy during a period of time.

Question 2

What are the 4 components of AD?

Answer 2

Consumer spending (C)
Investment (I)
Government spending (G)
Exports - imports (X-M)

Question 3

What is the relative importance of each component of AD?

Answer 3

• household consumption accounts for 60% of AD
• government spending accounts for approximately 25% of AD
• investment accounts for approximately 15% of AD
• exports - imports account for approximately 1%

Question 4

What does the aggregate demand curve show?

Answer 4

Shows the relationship between the level of AD and overall price, it shows planned expenditure at any given possible overall price level.

Question 5

Why does the AD curve slope downwards?

Answer 5

*real balance effect: an increase in the average price reduces the purchasing power so reduces the quantity of real output demanded.
*international competitiveness argument: at higher prices the economy is less likely to export goods, this decreases the X component and increases the M component so decreases AD.
*impact of interest rates: higher average prices the interest rate is likely to be higher meaning investment is lower.
A change in the average price level will cause a movement along the AD curve.

Question 6

What are the factors influencing consumer expenditure?

Answer 6

• real disposable income: this is the income an individual receives after paying tax. The higher the income the higher the spending power.
• rate of interest: increase in the rate will encourage saving, so decrease consumer expenditure.
• consumer confidence.
• wealth effects: a rise in average house prices would lead to increased consumer spending.
• state of the economy: if they feel confident they’ll spend more.

Question 7

What are the marginal and average propensities to consume and to save?

Answer 7

Marginal to consume: proportion of increase in income they’ll spend
Average to consume: proportion of income they’ll spend
Marginal to save: proportion of increase in income they’ll save
Average to save: proportion of income devoted to saving

Question 8

What are the influences on investment?

Answer 8

• interest rates: they have an inverse relationship. An increase in the interest rate will decrease investment and vice versa.
• access to credit: banks may not be willing to lend to firms.
• government regulations: they may encourage investment - cut corporation tax.
• business confidence: if firms are confident they’ll invest.
• animal spirits by Keynes: ‘naïve optimism’ businesses took too many risks.

Question 9

What are the influences on government spending?

Answer 9

• government fiscal policy

* the trade cycle

Question 10

What are the influences on net spending?

Answer 10

• real disposable income (home and abroad):
• increase income in UK, increased demand for imports
• increase income abroad, increased demand for exports
• exchange rate: SPICED
• government restrictions on free trade: tariffs and quotas
• non-price factors such a quality

Question 11

Circular flow of income:

Answer 11

Shows connections between different sectors of our economic systems.