Theme 2.6: The components of Aggregate Demand

Question 1

Equation of Aggregate Demand

Answer 1

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

Where:

AD = Aggregate demand
C = Consumption
I = Investment
G = Government spending
X = Exports
I = Imports

Question 2

Factors of consumption

Answer 2

Factors of consumption are:
Income
Interest rates
Consumer confidence 
Wealth effects
Taxes
Unemployment

Question 3

Consumption

Answer 3

Consumption is the total amount spent by households on goods and services.

Consumption is the largest component of aggregate demand - It makes up about 65% of AD in the UK.

When consumption is high savings tend to be low and vice versa.

Question 4

Disposable Income effect on consumption

Answer 4

As disposable income increases, consumption will rise.

Generally, the rate at which consumption rises is less than the rate at which increases because households will tend to save more.

Question 5

Interest Rates effect on consumption

Answer 5

higher interest rates lead to less consumer spending. This is due to:

• They will be more likely to save money.
• They will be less likely to borrow money or buy things on credit because it is more expensive.
• Consumers may also have less money to spend if interest rates on existing loans and mortgages increase.

Question 6

Consumer Confidence effect on consumption

Answer 6

when consumers feel more confident about the economy and their own financial situation, they spend more and save less. This is affected by many factors,
For example:
During a recession consumer confidence in the economy will be low - they might be worried for example about losing their jobs.

Question 7

Wealth effects on consumption

Answer 7

a rise in household wealth, e.g. due to the increase in house prices will often lead to increased consumer spending. This is due to consumer confidence.

Question 8

Taxes effect on consumption

Answer 8

direct tax increases lead to a fall in consumers’ disposable income, so they spend less.

An Indirect tax increase, increases the cost of spending, so spending will also fall.

A reduction in either tax will however lead to an increase in consumer spending.

Question 9

Unemployment effects on consumption

Answer 9

when unemployment rises, consumers tend to spend less and save more, due to increased fears of losing their jobs.

A fall in unemployment means more people have money to spend, and consumers are less worried about losing their jobs, so consumer spending increases.

Question 10

Investment

Answer 10

Investment is the money spent by firms on assets that they’ll use to produce goods or services

Firms invest with the intention of making a profit in the future

Investment makes up about 15% of AD in the UK

Question 11

Factors of investment

Answer 11

The factors of investment are:

• Risk
• Government incentive and regulation
• Intrest rates and access to credit
• Technical advances
• Business confidence and ‘animal spirits’

Question 12

Risk effects on investment

Answer 12

The level of risk involved will effect the amount of investment by firms.

If there is a high level of risk that a firm won’t benefit from it’s investment then it’s unlikely that the firm will invest.

For example, when there is economic instability, less investment will be made

Question 13

Government incentives and regulations effect on investment

Answer 13

Government incentives such as subsidies or reductions in tax can affect the level of investment.

For example, a reduction in corporation tax might encourage firms to invest, because they’ll have more funds available to do so.

A relaxing of government regulations might reduce a firm’s cost and make it more likely to invest.

Question 14

Interest rates and access to credit effects on investment

Answer 14

Firms often borrow money they want to invest. This means that when interest rates are high or firms are unable to access credit, investment tends to be lower.

High interest rates would reduce how profitable an investment would be (since interest charges on loans will be higher).

High interest rates will also mean there’s a greater opportunity cost of investing existing funds instead of putting them into a bank account.

Question 15

Technical Advances effect on investment

Answer 15

Firms need to invest in new technology to stay competitive.

Investment will rise when significant technological advances are made.

Question 16

Business confidence and ‘animal spirits

Answer 16

The more confident a business is in its ability to make profits (because demand for exports is high, for example) the more money it’s likely to invest.

But ‘business confidence’ depends partly on the general optimism or pessimism of the company’s managers.

Keynes recognised that not all investment decisions are based purely on reason and rational thinking, and that human emotion, intuition and ‘gut instinct’ are also important factors.

He called these factors ‘animal spirits’

Question 17

Government spending’s effect on Aggregate demand

Answer 17

`The government spending component of aggregate demand is the money spent by the government on public goods and services, e.g. education, health care, defence and so on.

Only money that directly contributes to the output of the economy is included - this means that transfers of money such as benefits (like the Jobseekers allowance) or pensions are not included.

Government spending is quite a large component of aggregate demand, so changes in government spending can have a big influence on aggregate demand.`

Question 18

Government spending and government revenue

Answer 18

A government budget outlines a governments planned spending and revenue next year.

If government spending is greater than its revenue, there will be a budget deficit

If government spending is less than its revenue, there will be a budget surplus.

Governments use fiscal policy to alter their spending and taxation to influence aggregate demand.

Question 19

Government and response to aggregate demand

Answer 19

If aggregate demand is low and economic growth is slow, or even negative, then a government may overspend (causing a budget deficit) in order to increase aggregate demand and boost economic growth.

If aggregate demand is high and economic growth is high and the economy is experiencing a boom, a government might increase taxes and spend less (causing a budget surplus) to try to reduce aggregate demand slow down economic growth.

Question 20

imbalance in the circular flow of income

Answer 20

An imbalance in the budget will affect the circular flow of income - a budget surplus will indicate an overall withdrawal from the circular flow, but a budget deficit will indicate an overall injection into the circular flow.

An imbalance in the budget is fine in the short run, but in the long run government will try to balance out any surpluses and deficits. A long term surplus might mean the government is harming economic growth by choosing not to spend, or by keeping taxes too high. A long run deficit is likely to mean a country has a large national debt.

Sometimes governments will balance the budget so that government spending will be equal to revenue. This should have little effect on aggregate demand.

Question 21

Factors that effect imports and exports

Answer 21

The exchange rate
Changes in the world economy
Degree of protectionism
Non-price factors

Net exports tend to make up a small percentage of aggregate demand, so changes in net exports in net exports have a minor impact on AD.

Question 22

SPICED

WPIDEC

Answer 22

Strong Pound Imports Cheap Exports Dear

Weak Pound Imports Dear Exports Cheap

Question 23

The exchange rate’ effect on Imports and Exports

Answer 23

A change in the value of a currency will affect net exports in different ways in the long and short run:
- In the long run - if the value of a currency increases, imports become relatively cheaper and exports become relatively more expensive for foreigners. As a result, demand for imports rises and demand for exports falls. So a strong currency (i.e. currency with a high value) will worsen net exports (X-M) in the long run and reduce aggregate demand , but a weak currency will have the opposite effect and improve net exports.

• In the short run - demand for imports and exports tend to be quite price inelastic. For example, some goods don’t have close substitutes, e.g. oil while others might have subsitutes, but there is a time lag before countries will switch to them - so in the short run demand won’t change much. This means that initally when the value of a currency increases, net exports will actually improve (increase) because the overall value of exports increase and the overall value of imports decreases.

Question 24

Changes of the state of the world economy and it’s effect on imports and exports

Answer 24

The higher a country’s real income, the more it tends to import. So net exports fall as real income rises.
The state of the world economy also affects exports and imports. For example, the USA exports lots of goods to Canada. If Canada goes through a period of low (or negative) growth then exports from the USA to Canada will decrease. Assuming imports are unaffected, this means a worsening in the USA’s net exports. Similarly, if Canada experiences high growth rates, exports from the USA are likely to increase - improving net exports.

Question 25

Degree of protectionism and it’s effects on imports and exports

Answer 25

In the short run, tariffs and quotas can increase net export by reducing imports. However, industries that are protected from international competition have few incentives to become more efficient, so will often export less in the long run. Also, in the long run, other countries may retaliate by introducing their own tariffs

Question 26

Non price factors of imports and exports

Answer 26

These include things such as the quality of goods. For example, advancements in technology in a country that lead to the production of higher quality of goods would be likely to cause an increase in exports from that country , because people are willing to pay more for something really good. This would mean an improvement in net exports.