Aggregate demand Flashcards
What is aggregate demand?
Aggregate demand is the total amount of planned spending on goods and services in the economy at any given price level.
What are the four components of aggregate demand?
1) Consumption (C)
2) Investment (I)
3) Government spending (G)
4) Exports minus imports (x-m).
Give two important features about the AD curve.
1) The diagram can be drawn as a straight line or curve.
2) Total expenditure by the economy remains much the same along the AD curve, this is called the real balance effect. This means when prices fall, people still spend approximately the same amount because they buy a higher quantity.
When does a movement along the AD curve occur?
Give an example.
Movements along the AD curve occur when there is a change in the price level caused by factors unrelated to aggregated demand, i.e. changes in aggregate supply.
For example, a fall in oil prices (causing a decrease in costs of production for all firms) would result in expansion of AD and a fall in the price level.
When does a shift in the AD curve occur?
A shift in the AD curve occurs when there is a change in one of the components of AD. The size of the change depends on the multiplier effect.
What will be the effect on the price level and real output when aggregate demand increases?
What will be the effect on the price level and real output when aggregate demand decreases?
If aggregate demand increases, we expect the average level of prices to rise (inflation) and real output to increase (economic growth)
If aggregate demand decreases, we expect the average level of prices to fall (deflation or falling prices) and real output to decrease (slow down or depression).
What is consumption?
What are the main determinants of consumption? (4)
Consumption is spending by households on goods and services, it is the main component of AD (around 65%). The main determinants are: 1) Interest rates 2) Consumer confidence 3) Wealth effects 4) The level of employment
How do interest rate affect consumption?
If interest rates rise then consumers are discouraged from spending because it costs more to borrow if spending on credit and increases the opportunity cost of spending.
Higher interest rates means that more can be earned by saving money in a bank.
How does consumer confidence affect consumption?
If householders feel confident in their jobs and future prospects for the economy, they are more likely to spend on big-ticket items such as cars or expensive electrical goods.
As a result what people think is going to happen in the economy has a big effect on what actually does happen.
How do wealth effects affect consumption?
An increase in share or house prices means that households are able and willing to spend more. For example people might be willing to take out a bigger loan on their house.
How does level of employment effect consumption?
The higher the level of employment, the more will be spent in an economy, which might lead to even more employment.
What is investment?
What are the 8 main determinants of investment?
Investment is defined as an increase in the capital stock, the determinants of investment are:
1) The rate of economic growth
2) Confidence levels
3) Interest rates
4) Animal spirits
5) Risk
6) Access to credit
7) Government decisions
8) Government bureaucracy
Explain how the rate of economic growth affects investment.
If there is an increase in real GDP, then firms will need more capital to meet the increase in demand.
Increase in real GDP causes a rise in investment and a rise investment causes a rise in real GDP.
Explain how confidence levels affect investment.
If business confidence is high and firms believe that they will be able to sell more in the future, they are more likely to invest.
Explain how interest rates affect investment.
If interest rates rise, investment tends to fall because it costs more to borrow money in order to invest.
Explain how animal spirits affect investment.
Sometimes consumers and firms do not act rationally, instead they act on gut instinct.
Explain how risk affects investment.
The higher the level of risk, the lower the level of investment.
Explain how access to credit affects investment.
Low interest rates do not necessarily means that all firms can borrow cheaply. Banks may not be willing to take risks in their lending.
Explain how government decisions affect investment.
Changes in government decisions and rules have a significant impact on capital spending, especially if firms are forced to face fines, if they do not react. Government policy may mean changes in tax rates which directly affect firms.
Explain how government bureaucracy affects investment.
Government bureaucracy is the level of government paperwork and regulation, that is required to make any business decisions. For example, relaxation of planning applications is likely to lead an increase in investment and building projects.
Define gross investment.
Gross investment is the total amount of investment before any account is taken of the depreciation of assets. Capital loses value as it wears out or becomes less efficient. Much investment in technology is quickly outdated.
Define net investment.
Net investment takes into account the fall of the value of capital assets. It is more useful as a sign of improvements in the prospects for the economy. It is the increase in capital less depreciation.
What is fiscal policy?
Fiscal policy is the government’s position or set of decisions on government spending and taxation.
What is a budget/fiscal deficit?
A budget deficit is where the government spends more than it earns, resulting in an increase in the flow of income or aggregate demand.
