2.2.4 Aggregate demand and the level of Economic activity

what is consumption

spending by households on goods and services. It is the largest component of Aggregate Demand. (primarly determined by disposable income)

what is disposable income

income avalible for spending after direct taxes and after adding government transfer payments such as benefits

what is disposable income split between

income and savings

what is the marginal propensity to income

MPC: the proportion of an increase in disposable income that is spent

What is the marginal propensity to save (MPS)

the proportion that is saved

What must MPC and MPs add up to

as the 2 shares must add up to 1

what are the 4 key influences on consumption

• Interest rates

• consumer confidence

• wealth effect

  • distribution of income

interest rates effect on consumption

higher rates raise the cost of borrowing and increase the reward for saving reducing consumption, lower rates do the reverse

How does consumer confidence influence consumption

when households are optimistic about their future income and the economy they spend and borrow more

how does the wealth effect affect consumption

a rise in household wealth such as higher house or share prices, makes households feel wealthier and spend more, falling wealth reduces consumption

How does the distribution of income affect consumption

a more equal distribution tends to raise consumption because lower income households have a higher MPC than higher income households

what is investment

spending by firms on capital goods such as machinery, factories and technology in order to increase future productive capacity

what is gross investment

total spending on new capital plus the replacement of worn out capital

Net investment

Net investment is gross investment minus depreciation — the net addition to the capital stock, which is what raises the economy's productive potential.

what is depreciation

the loss of value of capital goods over time due to wear and tear or obsolescence

what are the 6 key influences on investment

• rate of economic growth

• business confidence and ‘animal spirits’

• interest rates

• acsess to credit

• government policy and regulation

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How does the rate of economic growth affect investment

faster growth leads firms to expect higher future demand encouraging investment

how does business confidence and animal spirits encourage investment

optimism about the future driven partly by sentiment and emotion encourages investment, pessimism delays it

how do interst rates influence investment

lower rates= reduced cost of borrowing making investment more attractive

how does acsess to credit influence investment

easier acsess to finance makes it simpler for firms to fund capital projects

how does demand for exports influence investment

higher export demand can prompt investment in extra production capacity

how does government policy and regulation influence investment

tax incentives can encourage investment

regulation can discourage it

What is the short term impact of investment

Short run: Investment is a component of AD (AD = C + I + G + (X - M)), so a rise in investment increases aggregate demand, supporting growth and lower unemployment.

what is a long term impact of investment

Long run: Investment raises the economy's productive potential and can shift long-run aggregate supply (LRAS) to the right, supporting non-inflationary growth.

What is government spending

the spending by the govt on goods and services such as public services and infrastructure

it is a component of aggregate demand

What are the 3 key influences of govt spending

• the economic cycle

• discretionary fiscal policy

• political and social priorities

How does the economic cycle influence government spending

(automatic stabalizers) Spending changes automatically over the business cycle. In a recession it rises as welfare claims increase, supporting AD; in a boom it falls as welfare claims decline, helping cool the economy.

what is discretionary fiscal policy

governments can deliberately change spending - expansionary policy raises G (e.g on infrastructure to boost AD gorwth and employment while contractionary policy cuts G to reduce inflation or a budget defecit

how do political and social priorities influence government spending

spending also reflects manifesto commitements (e.g defence or hospitals)

demographic pressures such as an ageing population (pensions and healthcare) and long term supply side aims like infrastructure and education that shift LRAS to the right

what are the impacts of changes in government spending on ad

a increase in government spending directly increases AD its effects on real GDP, employment and inflation and depends on how much spare capacity there actually is

What are the impacts of a change in government spending on LRAS

spending on infastructure, education and technology can raise productive capacity and shift long run aggregate supply to the rightThis occurs as improvements in these areas enhance efficiency and productivity within the economy.

What is net trade

Net trade is the value of a country's exports minus its imports, affecting the overall balance of trade and aggregate demand.

What is the effect of a surplus on aggregate demand

adds to ad, a defecit subtracts from it

What are the 5 key influences on net trade

1. real income

2. exchange rates

3. state of the world economy

4. protectionism

   1. non-price factors

How does real income influence net trade

higher domestic real incomes increase spending on imports, worsening the trade balance

higher foreign incomes raise demand for exports, improving it

How do exchange rates influence net trade

a depreciation makes exports cheaper and imports dearer, improving the trade balance (an appreciation does the reverse)

the size of the effect depends on the PED for exports and imports so a depreciation may worsen the balance in the short run before improvising it in the long run

How does the state of the world eocnomy affect net trade

Global growth raises demand for exports and improves the balance, while a global recession worsens it.

This is often the most important short-run driver for the UK, a relatively open economy.

How does protectinism inlfuence net trade

Tariffs, quotas, and subsidies can reduce imports and improve the balance, but may provoke retaliation that reduces exports and raise prices for consumers.

how do non-price factors influence net trade

Quality, branding, and innovation affect competitiveness — stronger domestic competitiveness raises exports and improves the balance.

What is the accelerator effect

the idea that a rise in the rate of economic growth results in a larger percentage rise in investment

. Firms invest in new capital to meet higher expected demand, so a rise in national income can lead to a larger percentage rise in investment, which further boosts aggregate demand and growth.

how does the accelerator effect work in reverse

a fall in growth can lead to a larger percentage fall in investment, which further reduces aggregate demand and growth.