2.2 - Aggregate Demand Flashcards
What is aggregate demand?
Aggregate demand is the total amount of planned spending on goods and services at a given price level in an economy in a year.
what are the components of AD? and the formula
AD = C + I + G + (X - M)
1- Consumption
2- Investment
3- Government investment
4- Net trade
What is the relative importance of the components of Aggregate Demand?
1- Consumption: most significant component of AD and is about 60% of the total
2- Government expenditure: 25% of AD
3- Investment: 15% of AD
4- Net trade: Insignificant element of AD
Illustrate the AD curve
Downwards sloping curve with Price level on the Y-axis and RGDP on the X-axis
Why is the AD curve downwards sloping?
1- The real balance effect: when the price level rises the purchasing power of cash assets falls, which leads to a decrease in the demand for real output.
2- The international trade effect: a rise in the price level (relative to other countries) causes a decrease in the international competitiveness of UK goods, so causing a decrease in demand for exports and a rise in demand for imports. This results in a contraction of AD.
3- The interest rate effect: A higher price results in an increased demand for money. As a result, interest rates rise, reducing competition and investment and so causing a contraction in AD.
Illustrate an Increase of AD.
AD curve shifts to the right.
Illustrate a decrease of AD
AD curve shifts to the left.
What is consumption?
Consumption is spending by households on goods and services. The main determinant is disposable income.
What are the factors that effect consumption?
1- Disposable Income: the money people have available to spend on goods and services.
2- Interest Rates: when interest rates rise the cost of borrowing increases and the reward for saving increases, meaning consumption decreases.
3- Consumer confidence: If households feel secure in their jobs and their future prospects then they are more likely to spend more.
4- Wealth effects: when people feel wealthier (increases in house prices for home owners) they are more likely to spend more.
What is the Average propensity to consume and how is it calculated?
It is the proportion of disposable income that is spent on consumer goods and services.
APC = (Consumption / disposable income) x 100
What is Gross investment?
The total expenditure on new capital goods.
Gross investment = net investment + depreciation.
What is depreciation?
The fall in value of capital assets due to wear and tear and obsolescence.
What is Net investment?
New additions to capital stock after taking into account the fall in value of capital assets.
What are the factors of Investment?
1- Rate of Economic growth: Increase in economic growth causes a rise in investment.
2- Business expectations and confidence: if firms expect to sell more they will increase investment.
3- Animal spirits: the instincts and emotions that may determine whether a firm decides to invest.
4- Demand for exports: A rise in demand for a country’s goods from abroad is likely to stimulate investment.
5- Interest rates: if interest rates rise investment may fall as it costs more to borrow money in order to invest.
6- Access to credit: Banks may not be willing to take risks in their lending.
7- Government influence: the government may change tax rates which directly impact firms.
8- Government regulations
What factors impact Government expenditure?
1- The trade cycle: the government spends more in a recession e.g. on welfare payments.
2- Fiscal Policy: government expenditure and taxation.
What is net trade?
Net trade = imports - exports
What factors impact net trade?
1- Real income: higher income leads to an increase in demand for imports.
2- Changes in the exchange rate: If the exchange rate rises against other currencies, net exports are likely to fall because exports become less competitive and imports become more competitive in the domestic economy.
3- Changes in the state of the world economy: The value of UK exports its heavily dependant on growth rates around the world.
4- The degree of protection: If there are high tariffs or other restrictions on trade, firms may find it difficult to export to certain countries.
5- Non - price factors:
- Quality and design
- Reliability
- After-sales service
- Transport costs,
What are the 4 types of government expenditure?
1- Current expenditure
2- Capital expenditure
3- Current transfers
4- Interest repayments
What are the 18 factors of AD?
c
1- Disposable Income
2- Interest Rates
3- Wealth effects
4- Consumer confidence
I
1- Animal spirits
2- Business expectations
3- Access to credit
4- Economic growth rate
5- Government influence
6- Interest Rates
G
1- Trade cycle stage
2- Fiscal Policy
X-M
1- Exchange rates
2- Protectionism
3- Non-price factors
4- Domestic income
5- Foreign income
