Theme 2.6: The components of Aggregate Demand Flashcards
Equation of Aggregate Demand
AD = C + I + G + (X-M)
Where:
AD = Aggregate demand C = Consumption I = Investment G = Government spending X = Exports I = Imports
Factors of consumption
Factors of consumption are: Income Interest rates Consumer confidence Wealth effects Taxes Unemployment
Consumption
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.
Disposable Income effect on consumption
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.
Interest Rates effect on consumption
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.
Consumer Confidence effect on consumption
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.
Wealth effects on consumption
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.
Taxes effect on consumption
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.
Unemployment effects on consumption
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.
Investment
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
Factors of investment
The factors of investment are:
- Risk
- Government incentive and regulation
- Intrest rates and access to credit
- Technical advances
- Business confidence and ‘animal spirits’
Risk effects on investment
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
Government incentives and regulations effect on investment
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.
Interest rates and access to credit effects on investment
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.
Technical Advances effect on investment
Firms need to invest in new technology to stay competitive.
Investment will rise when significant technological advances are made.
Business confidence and ‘animal spirits
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’
Government spending’s effect on Aggregate demand
`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.`
Government spending and government revenue
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.
Government and response to aggregate demand
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.
imbalance in the circular flow of income
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.
Factors that effect imports and exports
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.
SPICED
WPIDEC
Strong Pound Imports Cheap Exports Dear
Weak Pound Imports Dear Exports Cheap
The exchange rate’ effect on Imports and Exports
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.
Changes of the state of the world economy and it’s effect on imports and exports
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.
