2.2 - Aggregate Demand

Question 1

What is aggregate demand?

Answer 1

The total level of spending in the economy at any given price.

Question 2

What is AD made up of?

Answer 2

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

Question 3

What is the AD curve?

Answer 3

Shows the relationship between price level and real GDP.
A rise in prices will cause a fall in real GDP.

Question 4

What is price level?

Answer 4

The average of prices for all goods and services in an economy.

Question 5

What is real national output (RNO)?

Answer 5

The output of the economy taking into account inflation.

Question 6

How is a rise in price shown on the curve?

Answer 6

A movement up the curve - contraction

Question 7

How is a fall in price shown on the curve?

Answer 7

A movement down the curve - expansion.

Question 8

What are the 4 key reasons that a rise in price causes a fall in real GDP?

Answer 8

Income effect
Real balance effect
Substitution effect
Interest rate effect

Question 9

What is the income effect?

Answer 9

A rise in price is not immediately matched by a rise in income, so lower real incomes mean people can buy less, contracting demand.

Question 10

What is the real balance effect?

Answer 10

A rise in price means saved up money will be worth less and encourage reduced spending. This also contracts demand.

Question 11

What is the substitution effect?

Answer 11

If prices rise, less foreigners want to buy British exports.
UK residents will also want to buy imported foreign goods, as they are cheaper.
This will decrease demand for exports, decreasing net exports and reducing AD.

Question 12

What is the interest rate effect?

Answer 12

When price levels rise, more money is needed for purchases / transactions, increasing demand for money which —> leads to higher interest rates.
This makes borrowing more expensive which encourages reduced spending, reducing aggregate demand.

Question 13

What is consumption?

Answer 13

Spending on consumer goods and services over a period of time.
Makes up 60% of AD.

Question 14

What is disposable income?

Answer 14

The money consumers have left to spend after taxes have been taken away.

Question 15

How does disposable income affect consumption?

Answer 15

The most important factor.
Those with higher income will be able to spend more. Marginal propensity to consume must be considered as higher income does not mean more consumption.
Poorer people are likely to have higher MPC.

Question 16

How do you calculate MPC?

Answer 16

Change in consumption / change in income

Question 17

How do you calculate APC?

Answer 17

Total consumption / total income

Question 18

What are savings?

Answer 18

What is not spent out of income.

Question 19

What is the relationship between savings and consumption?

Answer 19

As consumption increases, savings decrease.
The factors which affect consumption affect savings in the opposite way.

Question 20

How do interest rates affect consumption?

Answer 20

When interest rates rise, borrowing for credit becomes more expensive.
It may also increase mortgage repayments, so people have less disposable income overall.
AS INTEREST RATES RISE, CONSUMPTION FALLS

Question 21

How does consumer confidence affect consumption?

Answer 21

Confidence for the future and expected pay rises means more spending.
Predicted high inflation rates also encourages buying now rather than later, as it is cheaper.
However, if people expect recession and fear unemployment, they will try to save more and consume less.
AS CONFIDENCE RISES, CONSUMPTION RISES

Question 22

How does wealth affect consumption?

Answer 22

People with greater wealth tend to have greater levels of consumption.
When house prices rise, homeowners feel wealthier as their house is worth more. They tend to borrow more money if needed, increasing consumption,
Rising share prices also makes people feel more financially secure.
AS WEALTH, HOUSE / SHARE PRICES, RISE, CONSUMPTION RISES

Question 23

How does distribution of income affect consumption?

Answer 23

Those on higher incomes tend to save a higher % of their income, so less consumption.
If money is moved towards the poor, they have higher MPC.
THE POORER HAVE HIGHER MPC, INCREASING CONSUMPTION

Question 24

How do tastes / attitudes affect consumption?

Answer 24

Society has a strong materialistic drive to encourage people to buy the newest and the best, so spending and consumption is high.
THE NEWER/BETTER THE PRODUCT, THE HIGHER THE CONSUMPTION

Question 25

What is investment (I)?

Answer 25

Spending by a business on capital goods such as new equipment. Makes up about 15-20% of AD.

Question 26

What is gross investment?

Answer 26

The total amount spent on new capital goods.

Question 27

What is net investment?

Answer 27

This subtracts the amount spent on replacing worn out / outdated capital - known as depreciation. Net investment = gross investment - depreciation.

Question 28

How does the rate of economic growth affect investment?

Answer 28

A growing economy, demand is higher so businesses are more confident and want to meet high demand. They may need to increase machinery, increasing investments. **AS THE ECONOMY GROWS, INVESTMENTS INCREASE**

Question 29

How do business expectations / confidence affect consumption?

Answer 29

If future growth is expected, investments will increase - opposite if recession is feared.

Question 30

What idea did John Maynard Keynes introduce?

Answer 30

The concept of ‘animal spirits’ - a term to describe the feeling of whether investments are profitable.

Question 31

How does demand for exports affect investment?

Answer 31

If the world economy is high, demand for exports may increase. Exporting firms will need to produce more, so more investments. **AS DEMAND FOR EXPORTS INCREASES, INVESTMENTS INCREASE**

Question 32

How do interest rates affect investment?

Answer 32

If interest rates are high, borrowing becomes more expensive so businesses need to be confident about profits. Businesses may also use retained profits as a form of investment. If they choose to do this when interest rates are high, there is an opportunity cost on the money they could’ve received if they saved their retained profits instead.

Question 33

How does the influence of the government / regulations affect investment?

Answer 33

Governments may try to encourage businesses to invest things by introducing: tax breaks, which can reduce costs and *increase* profitability. Regulations may increase costs + time consumed, *discouraging* investments.

Question 34

How does access to credit affect investment?

Answer 34

When risk is high, getting access to credit is more difficult because banks are more risk aware and are more reluctant to lend money as they fear firms won’t be able to pay it back. **LOWER ACCESS TO CREDIT, LOWER INVESTMENTS**

Question 35

How does changes in technology affect investment?

Answer 35

Improvements in technology will improve the production process which increases profitability. This means the investment has better chance of success.

Question 36

How do costs affect investment?

Answer 36

Increased costs can reduce profits + cash flow, making it harder to cover expenses. This creates uncertainty and forced businesses to make *riskier* decisions, reducing chances of investment. **AS COSTS INCREASE, INVESTMENTS FALL**

Question 37

What is government spending?

Answer 37

Focuses on providing goods + services, wages and salaries, and other infrastructure. Makes up around 18-20% of GDP.

Question 38

How does a rise in taxation affect government spending, and in turn AD?

Answer 38

An increase in tax raises government revenue, which allows government to increase spending. This is based on the governments fiscal policy objectives: If the government uses the additional tax revenue to increase spending, AD may rise. If instead they use it to reduce national debt, AD may fall.

Question 39

What are the potential indirect effects of higher taxation for consumers and businesses on AD?

Answer 39

Higher tax on individuals can reduce disposable income, which can reduce consumer spending. For businesses, they may be less confident to invest, as they face higher costs. This can reduce overall AD in the economy.

Question 40

How does the trade cycle affect government spending?

Answer 40

If the economy is in *recession*, the government will increase spending on things such as social programmes and unemployment benefits in order to boost demand. If the economy is *growing too fast* the government may try to reduce spending to decrease demand and regulate inflation.

Question 41

How does the fiscal policy affect government spending?

Answer 41

Fiscal policy is the decisions made about government spending and taxes and will depend on government priorities. Governments vary spending from year to year, and the is set out in their *budget*.

Question 42

How does age distribution of the population affect government spending?

Answer 42

An ageing population leads to increased government expenditure on *pensions, social care, *healthcare, etc*. A younger population may lead to increased spending on *education, community development, etc*.

Question 43

What is net trade? (X-M)

Answer 43

This is the total exports - total imports. This will be a *negative* figure if **imports and higher than exports**. A *deficit* value in the UK. Makes up around 5% of AD.

Question 44

How does real income affect net trade?

Answer 44

When income is high, people demand more goods. Since the UK cannot always meet this demand, imports increase. However, high income may also be because businesses are producing and selling more goods to other countries, increasing exports.

Question 45

How do exchange rates affect net trade?

Answer 45

A *strong* pound means imports are cheaper and exports are more expensive to foreign buyers. This increases imports and decreases exports - overall **decrease in net trade**. The elasticity of imports and exports will impact their value, affecting the demand for those goods.

Question 46

How does the elasticity of goods affect net trade?

Answer 46

If prices of UK exports drop - and the goods are elastic - demand for them will increase by a lot, raising their value. Vice versa. If imports / exports are inelastic, demand won’t change much, even if prices change.

Question 47

How does the state of the world economy affect net trade?

Answer 47

Depends on the UK’s main trade countries. If their main export country is doing well, UK exports will increase, also increasing net trade. The same applies for the other way round.

Question 48

How does the degree of protectionism affect net trade?

Answer 48

This is an attempt to protect *domestic producers* from suffering foreign competition. When protectionism is high in **other countries**, it’s harder and more expensive for UK businesses to sell goods abroad - exports decrease, so net trade falls. If protectionism is high in **the UK**, local businesses are benefitted by reducing competition, reducing UK imports and improving net trade. However long term, this may lead to retaliation from other countries, affect long-term exports.

Question 49

How do non-price factors affect net trade?

Answer 49

The factors can be things such as quality, design, and marketing. When UK good are of higher quality and design, exports will increase. Imports will decrease because locals will buy British goods over foreign goods, increasing net trade. Well marketed UK goods will also encourage purchase, affecting net trade in the same way.

Question 50

How do prices affect net trade?

Answer 50

When UK goods’ prices are high, they are *less competitive* compared to foreign goods, increasing imports. If the UK inflation rate is higher than in other countries, prices will rise faster. Changes in prices may be due to *productivity*, as higher productivity can reduce costs and therefore may lead to lower prices. The impact this has on the value of imports/exports depends on PED. Higher prices on exports —> foreign consumers will buy less —> decreases UK exports —> reduced net trade.