2.2 - Aggregate demand

Question 1

What is aggregate demand?

Answer 1

The total value of planned expenditure on goods and services produced in an economy in a given period of time

Question 2

What are the components of aggregate demand? What are the percentages?

Answer 2

• AD=C+I+G+(X-M)
• C = 60%
• I = 14%
• G = 25%
• (X-M) = 1%

Question 3

What is the distinction between a movement along, and a shift of, the AD curve?

Answer 3

• Movements along the AD curve are caused by a change in the average price level (inverse relationship) - a rise in the average price level leads to a contraction of AD
• AD shifts because of a change in any of consumption, investment, government spending, exports or imports. This can be caused by changes in behaviour or changes in government policy

Question 4

What can a change in average price level lead to?

Answer 4

Changes in average price level can lead to several things:
- Real incomes: A rise in the average price level can lead to the real value of income to drop.
- Balance of trade: If the average price level of a foreign country fell, domestic consumers would demand more imports, causing a contraction in AD.
- Interest rates: If the average price level rises, there will be inflation.

Question 5

What is a demand side shock?

Answer 5

A demand-side shock is anything (positive or negative) that causes AD to change.

Examples of a negative shock could be an interest rate rise, a collapse in the housing market, etc

As well as a fall in real GDP, this could have a knock-on effect on confidence, leading to further falls in activity

Question 6

What are the features of the AD curve?

Answer 6

• Downward sloping
• Consumption will fall as the price level rises - a movement (not a shift) along the AD curve

Question 7

What does disposable income and savings mean and what is the importance of the savings ratio? (What is China’s savings ratio (case-study) ?)

Answer 7

• Disposable income is the amount of money that people have left after paying their income taxes.
• An increase in disposable income will lead to an increase in consumer spending
• China = 30%

Question 8

What is MPC?

Answer 8

Marginal propensity to consume: how much of an increase in household income is consumed or spent

Change in consumption / Change in income

Question 9

What is the relationship between savings and consumption? (savings ratio)

Answer 9

• Savings is the part of disposable income that is not spent on things like food, clothing and rent.
• The savings ratio is the ratio of savings to income (S/Y)
• If the savings ratio rises, it is likely that consumption will fall. This is because: savings + consumption = disposable income

Question 10

What other factors influence consumer spending?

Answer 10

• The interest rate
• Level of consumer confidence in the future
• Wealth effects
• Inflation expectations
• Level of income
• Availability of credit

Question 11

How do interest rates influence consumption? What is the current interest rate?

Answer 11

• If interest rate rises, then saving is more attractive, so consumers will spend less and save more
• Base rate = 4.25%

Question 12

How does inflation influence consumption? What is the current inflation rate?

Answer 12

• If inflation increases, it will be more expensive to purchase goods and services so consumption will be discouraged
• Inflation = 2.6%

Question 13

How does level of consumer confidence in the future influence consumption?

Answer 13

If confidence is low, consumers will spend less and save more.

Question 14

How does the wealth effect influence consumption?

Answer 14

This happens if asset prices rise and consumers feel as though they have more money. They may spend more if share prices or property prices rise.

Question 15

How does level of income influence consumption?

Answer 15

People with higher incomes tend to save more: they have a higher marginal propensity to save, that is for every extra pound people get, they save more as they get richer

Question 16

What is the life-cycle hypothesis?

Answer 16

The theory states that individuals seek to smooth consumption over the course of a lifetime – borrowing in times of low-income and saving during periods of high income.

The graph shows individuals save from the age of 20 to 65:
- As a student, it is rational to borrow to fund education.
- Then during your working life, you pay off student loans and begin saving for retirement
- This saving during working life enables you to maintain similar levels of income during your retirement

Question 17

How does availability of credit influence consumption?

Answer 17

This refers to how easy it is to borrow money

Question 18

How do pensions influence consumption? Give real-world examples.

Answer 18

• A decrease in pension payments -> people save up more -> decreased consumption -> decreased AD
• Greek people were previously entitled to a pension worth 80% of earnings - Greek government cut this to 60%
• April 2017 - UK gov increased state pensions from £155.65/wk to £159.55/wk

Question 19

What is the distinction between gross and net investment?

Answer 19

Gross investment is the total amount that the economy spends on new capital
Net investment = gross investment - capital depreciation

Question 20

What factors influence investment?

Answer 20

• Rate of economic growth
• Business expectations & confidence
• Keynes’ animal spirits
• Export demand
• Interest rates
• Access to credit
• Government & regulation
• Profitability
• Accelerator effect

Question 21

How does the rate of economic growth influence investment?

Answer 21

• Usually measured as a % of GDP
• If GDP rises, then investment is likely to rise too
• High economic growth signals economic strength - gives businesses confidence in the future - will invest to increase their productive capacity, expecting increases in demand to continue in the future

Question 22

How does business confidence and expectations influence investment?

Answer 22

If businesses expect demand for their goods & services to continue rising - likely to invest to increase their productive capacity

Question 23

How does Keynes’ idea of animal spirits influence investment?

Answer 23

Firms will be overoptimistic and invest excessively in good times, before reducing investment too much when consumer spending is lower and business confidence is weaker

Question 24

How does export demand influence investment?

Answer 24

A component of aggregate demand - if international demand for a firm/nation’s goods rose, it’s likely they would invest to increase productive capacity

Question 25

How do interest rates and access to credit influence investment?

Answer 25

- Low interest rates = less debt = more likely to borrow & invest it - Higher access to credit makes it more likely that firms will be able to borrow to invest

Question 26

How does the accelerator effect influence investment?

Answer 26

This is when an increase in GDP results in a proportionally larger rise in capital investment spending

Question 27

How does government and regulation influence investment?

Answer 27

Governments can subsidise or encourage investment in certain industries e.g healthcare

Question 28

How does profitability influence investment?

Answer 28

If firms have more profits, they have greater funds with which to purchase new capital, expand existing factories

Question 29

How does the trade cycle influence government spending?

Answer 29

The trade cycle displays a country's economic growth. - The fluctuations account for different phases: economic growth, peak, economic downturn & trough - In an economic boom, there is more spending and higher incomes which means the government receives more tax. The government also pays less benefits.

Question 30

How does age distribution of a population influence government expenditure?

Answer 30

An ageing population leads to increased expenditure on pensions, social care etc, whilst a younger population leads to increased spending on education. More dependents usually = greater spending

Question 31

What is fiscal policy?

Answer 31

A government's policy regarding taxation and public spending to achieve macroeconomic objectives through shifting AD

Question 32

What is loose fiscal policy?

Answer 32

Increased spending and lower tax revenue to boost economic activity

Question 33

What is tight fiscal policy?

Answer 33

Cutting spending and raising extra tax revenue, resulting in slower growth

Question 34

What are automatic stabilisers?

Answer 34

Fiscal policy tools to influence GDP and counter fluctuations in the economic cycle without any deliberate government action, such as changes in tax revenues & welfare spending that vary with GDP

Question 35

How does fiscal policy influence government spending?

Answer 35

Fiscal policy is the decisions about taxes and government spending and it will depend on the priorities of the government. The level of government spending depends on what they lay out in their fiscal policy

Question 36

What is the net trade balance?

Answer 36

The net trade balance is the difference between the value of the exports and imports

Question 37

What factors influence net trade?

Answer 37

- Price - Real income - Exchange rates - State of the world economy - Degree of protectionism - Non-price factors (P.R.E.S.D.N)

Question 38

How do exchange rates influence net trade?

Answer 38

S.P.I.C.E.D - Strong Pound Imports Cheaper Exports Cheaper W.P.I.D.E.C - Weak Pound Imports Dearer Exports Cheaper

Question 39

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

Answer 39

- If the UK's main export country is doing well then exports are likely to rise thus net trade will rise - The effect of the state of the world economy is dependent on which countries are doing well and the trade relationship the UK has with them

Question 40

How does the degree of protectionism influence net trade?

Answer 40

Protectionism is an attempt to prevent domestic producers suffering from competition abroad (improve ratio of exports to imports) e.g. tariffs and quotas are physical barriers which make it harder for producers from abroad to sell their goods in the UK

Question 41

How does real income influence net trade?

Answer 41

When real income is high, MPM tends to increase as people demand more goods and services and the UK is unable to meet their needs - net trade decreases

Question 42

How do price factors influence net trade?

Answer 42

- High prices of UK goods = less competitiveness compared to international goods = volume of exports decreases and imports increase - If UK inflation rate is higher than other countries, prices will rise faster - High productivity = low cost = low price - If PED is elastic, higher prices = fall in net trade

Question 43

How do non-price factors influence net trade?

Answer 43

- If UK goods are higher quality, exports will be high as foreign demand for UK goods will increase - imports will also decrease as people opt for British goods - If UK goods are well marketed, consumers will have a stronger desire to buy British goods - exports will increase, imports will decrease

Question 44

What are some cyclical causes of a trade deficit?

Answer 44

- Rising real incomes - leads to an increased demand for imports especially goods and services with a high YED - Increasing consumer spending - perhaps financed by borrowing/debt - as consumption grows (and savings fall) - imports rises - Expanding production - businesses need to import more raw materials - Growing investment spending - e.g. large amounts of new capital machinery and technology from overseas - Strong exchange rate - S.P.I.C.E.D - depends on the price PED for exports and imports -> stronger currency = larger trade deficit