The AD/AS model

What is Aggregate Demand (AD)?

The total demand in the economy, measuring spending by consumers, firms, the government, and overseas buyers.

What is the formula for AD?

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

Why is consumer spending (C) the most important component of AD?

It makes up about 60% of GDP, meaning changes in consumer spending have a significant impact on economic growth.

What factors influence consumer spending?

1. Interest rates – Lower rates make borrowing cheaper and reduce the incentive to save, increasing spending.

2. Consumer confidence – If people expect higher income and stable jobs, they spend more.

3. Disposable income – Higher income after tax and deductions means more spending power.

What proportion of GDP does investment contribute to in the UK?

Around 15-20%, with ¾ from private firms and ¼ from government spending.

What are the key factors influencing investment?

1. Economic growth – Higher growth means higher profits, leading to more investment.

2. Business confidence & expectations – Uncertainty reduces investment; confidence increases it.

3. Interest rates – Lower rates reduce borrowing costs, making investment more attractive.

4. Access to credit – If banks restrict lending (e.g., after 2008 financial crisis), investment falls.

5. Government & regulations – Lower corporation tax increases profits available for investment.

What did Keynes mean by "animal spirits"?

Business confidence and instincts that influence investment decisions.

What proportion of GDP does government spending contribute?

Around 18-20%.

Why are transfer payments not included in government spending in AD?

They do not involve purchasing goods/services, just redistributing income (e.g., benefits, pensions).

How does fiscal policy affect government spending?

1. Expansionary fiscal policy → More spending and tax cuts (used during recessions).

2. Contractionary fiscal policy → Less spending and tax increases (used during growth periods to reduce debt).

How does economic growth influence government spending?

• During recessions → Governments increase spending (e.g., welfare payments) to stimulate AD.

• During booms → Governments reduce spending as the economy needs less stimulus.

What does (X - M) represent?

Exports (X) minus imports (M), showing the trade balance. A positive value means a surplus; a negative value means a deficit.

What factors influence net exports?

1. Real income – Higher incomes mean more imports, worsening the trade balance.

2. Exchange rates – A weaker currency makes exports cheaper and imports more expensive, improving the balance.

3. State of the world economy – If the UK’s trading partners are in recession, demand for UK exports falls.

4. Protectionism – Tariffs and quotas reduce imports, improving the trade balance, but may lead to retaliation.

5. Competitiveness – Innovation, quality, and lower production costs make exports more attractive.

Why is the SRAS curve upward sloping?

Higher price levels mean firms can make more profit, so they increase output.

What factors shift SRAS?

• Wage changes – Higher wages increase costs, shifting SRAS left.

• Raw material costs – Higher costs (e.g., oil prices) reduce supply.

• Exchange rates – A stronger currency makes imports cheaper, shifting SRAS right.

• Government intervention – More regulation increases costs, shifting SRAS left.

What does the LRAS curve represent?

The economy’s full capacity output, where all factors of production are fully employed.

What factors shift LRAS?

1. Technological advances – More efficient production increases potential output.

2. Labour productivity – A more skilled workforce increases output.

3. Education & skills – Improves workforce quality, shifting LRAS right.

4. Infrastructure investment – Better transport and communication increase efficiency.

5. Competition policy – Encourages efficiency and innovation.

What is the multiplier effect?

When an initial increase in spending leads to a larger increase in national income due to repeated rounds of spending.

When is the multiplier effect strongest?

When there is spare capacity, allowing firms to produce more without price rises.

What is the reverse multiplier?

A fall in spending causing a greater overall decrease in national income (e.g., government cuts leading to job losses and lower consumption).

What causes AD to shift right (increase)?

• Higher confidence – More spending & investment.

• Lower interest rates – Cheaper borrowing, reduced incentive to save.

• Tax cuts – More disposable income.

• Increased government spending – Boosts AD.

• Weaker currency – Exports up, imports down.

What causes AS to shift right (increase)?

• Lower input costs – Cheaper wages, materials, or imports.

• Higher productivity – More output per worker.

• Technological improvements – Efficient production.

• Less regulation – Lower costs for firms.

• Skilled migration – More productive workforce.