2.2 - Aggregate Demand

Question 1

What is aggregate demand?

Answer 1

The total planned expenditure on goods and services produces in an economy over a period of time. It comprises of consumption (C), investment (I), govt expenditure (G), and net exports (X-M).
AD = C + I + G + (X-M)

Question 2

Why is the AD curve downward-sloping?

Answer 2

• lower prices in an economy mean increased international competitiveness, so there are more x and less m. So net x are higher at lower prices.
• total expenditure by the economy remains much the same along the AD curve. When there is a fall in the price level, people still spend approximately the same amount but they buy a larger amount of goods and services.
• at higher price levels, interest rates are more likely to be raised by the monetary authorities. This means that investment falls and savings might increase.

Question 3

What is consumption?

Answer 3

Spending by households on goods and services. It’s the naughty crinoline then if aggregate demand, comprising about 60%. To measures the amount that consumers are willing to spend at various price levels. The higher the disposable income (income after tax) the higher consumption.

Question 4

Determinants of consumption

Answer 4

• disposable income: higher then C is higher
• consumer confidence: from job security and future income, C increases if confidence is higher
• interest rates: higher mean consumers have less spending money after mortgage payments. Also increases borrowing so saving is better
• wealth effect: inc in house or share prices make people feel better of so households spend more
• level of employment: high then more money spent

Question 5

What is investment?

Answer 5

An increase in the capital stock. It is creating assets that will generate income in the future rather than in the immediate term. Forms around 10-15% of AD.

Question 6

Gross vs net investment

Answer 6

Gross: the total amount of investment before any account is taken of depreciation of assets. Capital loses valid as it wastes out it becomes less efficient.
Net: takes into account the fall in value of capital assets. It’s more significant for changes in the productivity of an economy and its productive potential.

Question 7

Determinants of investment

Answer 7

• interest rates: an inverse relationship between IR and I because it costs more to borrow the money in order to invest
• profits: many businesses finance their investment from retained profits.
• taxation: if corporation tax is high then funds for investment that firms have may fall
• govt policy: if govt follows reflationary policy then spending will rise and investment may be stimulated
• exchange rate: low exchange rate makes exports more competitive so demand for them increases. This may encourage investment as prospect of profits increases.
• access to credit: how keen banks are to lend can have an impact on I
• new technology: if new tech can increase productivity and reduce unit costs then firms have greater incentives to invest
• business confidence: inc confidence leads to increased I

Question 8

What are animal spirits?

Answer 8

The forces that make markets move in large booms and Budd, as people buy and sell impulsively rather than calmly using pure rational behaviour. Decisions to invest were described by Keynes as irrational behaviour, known as animal spirits.

Question 9

What is government expenditure?

Answer 9

The money the govt spends. It comprises 40% of all spending in the economy but 25% of AD. This is because a large part of G is paid out as transfer payments, which are really a movement of spending power from taxpayers to consumers so features as C.

Question 10

Determinants of government expenditure

Answer 10

Fiscal policy:
-fiscal deficit: G>T inc AD
-fiscal surplus: T>G dec AD
Business cycle:
-spends more in a recession as benefits inc and tax revenue falls
-spends less in a boom as benefits dec and taxation rises as workers and firms are able to earn more.

Question 11

What are net exports?

Answer 11

Exports minus imports. Exports represent an inflow of money and imports are an outflow of money.

Question 12

Determinants of net exports

Answer 12

• changes in real incomes: if real incomes rise more rapidly in the UK than elsewhere, imports will rise
• changes in exchange rates: SPICED (strong pound imports cheap exports dear)
• changes in the global economy: if US faces recession they buy less x from UK. If inflation is higher domestically then net x will worsen as goods become uncompetitive. Stock market crashes in other countries may also have an effect via the wealth effect.
• degree of protectionism: if US imposes tax or tariff on imports then UK x will fall
• non-price factors: quality and after sales services