2.2 Aggregate Demand Flashcards
Aggregate Demand
Total level of spending in the economy at any given price over a given time period
AD Formula
C + I + G + (X - M)
Components of AD
Consumption - consumer spending on goods and services
Investments - spending on capital goods
Government Spending - spending on public and merit goods by government
Net Trade - exports minus imports
AD Curve
Same as demand curve but shows relationship between price level and real GDP
Downward Sloping:
- Income Effect
- Substitution Effect
- Real Balance Effect
- Interest Rate Effect
AD Curve
Income Effect
As a rise in prices is not matched by rise in income, people have lower real incomes so can afford to buy less leading to a contraction in demand
AD Curve
Substitution Effect
If prices in UK rise, less foreigners will want to buy British exports and more UK residents will want to buy imported foreign goods as they are cheaper
Rise in imports and fall of exports decreases net trade so AD will contract
AD Curve
Real Balance Effect
Rise in prices will mean amount people have saved will no longer be worth as much so will offer less security
As a result, they will want to save more and reduce spending
Contraction in AD
AD Curve
Interest Rate Effect
Rising prices means firm have to pay workers more thus there is higher demands for money
If supply stays the same, price of money (interest rates) will rise
Higher interest rates mean more people save and less borrow and will mean businesses invest less
Contraction in AD
Movements and Shifts
Movement is caused by change in prices
Shift is caused by any other variable
A fall in consumption reduces AD but fall in rate of rise of consumption means consumption is still rising so AD will increase but by not as much
Disposable Income (Y)
Money consumers have left to spend after taxes
Most important factor in determining consumption levels
Marginal propensity to consume (MPC)
Average propensity to consume (APC)
Marginal Propensity to Consume
How much an increase in income affects consumptions
0 - 1 = income increase increases spending but spending doesn’t increase as much
1+ = use borrowing or savings to fulfil demand for goods which is higher than their income increase
Poor likely to have higher MPC than rich
= Change in Consumption / Change in Income
Average Propensity to Consume
Average amount spent on consumption out of total income
APC for economy is likely to be less than 1 in an industrialised country
= Total Consumption / Total Income
Relationship between savings and consumption
Saving is what is not spent from income
Increase in consumption decreases savings => factors affecting consumption are same for savings but in the opposite way
Marginal propensity to save (MPS) is how much an increase in income is saved whilst average propensity to save (APS) is average amount saved from income
MPS and APS formulas
MPS = Change in Savings / Change in Income
APS = Total Savings / Total Income
Influences on Consumer Spending
Disposable Income Interest Rates Consumer Confidence Wealth Effects Distribution of Income Tastes and Attitudes
Influences on Consumer Spending
Interest Rates
Most major expenditures are bought on credit so interest rate affects cost of good for consumers
If rates are high, price of good will effectively be higher since more interests needs to be paid back => fall in consumption
High rates also increase mortgage repayments => fall in consumption
Rise in rates decreases value of shares => negative wealth effect
Influences on Consumer Spending
Consumer Confidence
If people are confident about future and expect pay rises, they will continue or increase spending
If they expect high inflation, they will buy now at cheaper price => increased consumption
Recession or unemployment => reduced consumption
Tax also has same effect
Influences on Consumer Spending
Wealth Effects
Wealth is a stock of assets
People with greater wealth have greater levels of consumption
Wealth effect is experienced when real house prices rise as owners now have more wealth so are more confident with spending
Also experienced when share prices rise
Greater wealth increases consumer confidence => increased spending
Influences on Consumer Spending
Distribution of Income
Those on high incomes tend to save higher percentage of incomes than those on low so a change in distribution of money in economy will affect level of consumption
If money is moved from rich to poor, consumption is likely to increase as poor have higher MPC
Influences on Consumer Spending
Tastes and Attitudes
There is a strong materialistic drive encouraging people to have the newest and best => spending is high, sometimes even above income
If people were less materialistic, consumption would decrease
Investment
Additional of capital stock to an economy
Only seen as investment if real products are created so buying a share in a company would be saving but new machinery is investments
Gross and Net Investment
Gross investment is amount of investment carried out and ignores level of depreciation
Net investment is gross investment minus value of depreciation
Influences on Investment
Rate of Economic Growth Business Expectations and Confidence Demand for Exports Interest Rates Influence of Government and Regulations Access to Credit Retained Profit Technological Change Costs
Influences on Investment
Rate of Economic Growth
Higher levels of investment in a growing economy as business would be more confident about their investments and higher demand leads to higher return rate on investments
Growing economies need more investments in order to cope with higher levels of demand
Vice versa for an economy in decline
If same products and same output is being produced every year and demand is constant, investment will stay same as firms only need to replace old machines
Accelerator Theory
