3.2.2.3 THE DETERMINANTS OF AGGREAGTE DEMAND

What is aggregate demand?

Total planned spending on real output in the economy at different price levels

In a given time period - Eg. A year

What is the AD calculation?

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

What does each letter stand for?

C - consumption

I - investment

G - government spending

X - exports

M - imports

Why is the X - M in brackets?

The (X - M) is in an open economy

The rest (outside brackets) is in a closed economy

Who came up with this equation?

John Maynard Keynes

What does the AD curve look like?

Why does the curve slope downwards? (3)

• falling real incomes

• balance of trade

• interest rate effect

What factor affect inflation?

The Bank of England interest rates - if inflation increases, interest rates tend to increase

This causes AD to decrease - AD shifts inwards - then decreasing inflation

What are some causes of a shift in the AD curve?

• consumer confidence

• government spending

• taxes

• interest rates

• exchange rates

• investments.

What causes a movement along the AD curve?

The overall price level changes

If the arrow goes up the line, what is it called?

Contraction

If the arrows goes down the line, what is this called?

Extension

If price level falls, real GDP demanded increases

Is it an upwards or downwards movement on the curve?

Movement down the AD curve

If price level rises, real GDP demanded decreases

It is an upwards or downwards movement on the curve?

Movement up the AD curve

If there is a lower price level

What does this mean for consumers, interest rates, exports?

Consumers - have more confidence to spend, AD increases

Interest rates - lowered, more borrowing, higher AD

Exports - more competitive, AD increases

Photo of the aggregate demand curve?

Who have expectations?

Consumers, businesses, investors

What is an AO4 (evaluation) of expectations?

Some people disagree with expectations as consumers just buy when they need something

If households expect higher future income, they spend, how does this shift AD?

AD shifts to the right

If businesses expect lower profits, they may reduce investment

How does this shift AD?

AD shifts to the left

What are the 2 theories of expectations?

1 - if consumers expect prices will rise in the future, they may buy more goods at that point

2 - some people feel that consumers just buy what they need at that time - and don’t think about the future

Define rate of interest

The cost of borrowing money or the reward for saving

Expressed as a % of the amount borrowed or saved over a period of time

What is a basic definition of interest rates?

The value of money

Define life cycle theory of consumption

A theory which suggests that individuals plan their consumptions and savings behavior over their lifetime

Examples of a life stage consumption?

• buying a house

• having a baby

Impacts their consumption behavior

Define availability of credit

The ease at which house holds and firms can borrow money from banks and other financial institutions to finance consumption or investments

Define credit crunch

A sudden reduction in the general availability of credit or a sudden tightening of the conditions required to obtain a loan from a banks and other lenders

What caused a credit crunch?

A decrease in the availability in credit led to the Global Financial Crisis - as business and households couldn't borrow money

What is progressive tax?

Affects the wealthiest people

Example of a progressive tax?

Income tax - tries to redistribute wealth

What is regressive tax?

Affects the poorest people

Example of regressive tax?

VAT - affects the poorest people

Is VAT an indirect or direct tax? Why?

Indirect - only affects you if you purchase a good

What does Keynes call consumer confidence?

"Animal spirits"

What does MPC mean?

MPC - marginal propensity to consume

What does MPS mean?

MPS - marginal propensity to save

What is an example of a cause of an outwards shift in AD?

When interest rates are low, consumers have a propensity to borrow more money

This causes a shift outwards/to the right

If there is only a change in price, what happens to the curve?

There is a movement along the AD curve

What does this equation mean?

Y = C + S

Y - income (spent or saved)

C - consumption

S - saving

It reflects the households use of income in a closed economy (in taxes or government spending)

What is the difference between saving and investment?

Saving -the portion of income that is not spent on consumption

Investment - spending by firms on capital goods (machinery, buildings, tools) that will produce future output

What do businesses tend to do? (Save or invest?)

Typically invest

What does households tend to do? (Save or invest?)

Typically save

What is the AD equation?

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

Key factors the determine business investment?

• actual and expected demand

• expected profits and business taxes

• business confidence (eg. animal spirits)

• interest rates and availability of business finance

• encourages businesses/firms to reduce or increase investment

What does a higher level of investment raise?

Both actual and potential GDP

What are some examples of the determinants of investment?

• interest rates (if increase rates are decreased, cost of borrowing decreases, investment and consumption rises)

Consumers buy big things - cars, houses

• the relative prices of capital and labour (firms invest)

• technical progress

• expectations

What is the relative prices of capital and labour?

Costs of production

What are some examples of the determinants of government spending?

• government policy (large projects - government investment - creates jobs - boosts household incomes - higher consumption) (capital and current spending)

• economic cycle (firms expect higher sales - increase investment) (consumers feel more confidence - increased consumption)

• elections

What is current spending?

The government spending on day to day spending (nurses, doctors, paramedics wages)

What is capital spending?

Spending on long term aspects

New terminal at an airport, new runways at Heathrow

What does the economic cycle look like?

Real GDP on the y axis

Time on the x axis

A straight line

With lines intersecting - going above and below

Above - the positive output gap

Below - the negative output gap

With 4 labels - boom, downturn, recession, recovery

What are the years 1997 - 2007 called? Why?

The NICE years (Non-inflationary continuous economic growth)

How does elections influence the determinants of government spending?

Tax cuts - higher disposal incomes - higher consumption

Higher government spending - increased G

Public sector pay rises - increased consumption

What is the balance of trade?

The difference in value between imports and exports

What are some examples of the determinants of balance of trade?

• exchange rates (exports become cheaper for foreign buyers - exports rises, imports become moor expensive, so imports decrease)

• factor endowments - higher production - firms expand and invest, consumption rises

• efficiency and productivity

• innovation and design

• consumer tastes

• level of AD

What are factor endowments?

Factors of production - land, labour, capital, enterprise

What is a basic definition of exchange rates?

The value of money

The price of a currency compared to another currency (eg. The pound and the dollar)

In terms of strong and weak pound, what are the WORDS to remember?

SPICED - Strong Pound Imports Cheap Exports Dear

WPIDEC - Weak Pound Imports Dear Exports Cheap

What does a cheaper pound mean for foreigners?

Makes it cheaper for foreigners

If the ratio is £1 : $4, what does this mean for the UK and the US? (A strong pound)

• good for tourists in the UK

• bad for the UK - may struggle to sell and export

• but on the other hand, easier for the UK to buy than USA material

So what would be an example of a weaker pound?

£1 : $1.30

Examples of things that increase AD?

• cut in taxes

• depreciation of the exchange rate

• increase in house prices

• lower interest rates

• expansion in the supply of credit

Example of things that decrease AD?

• cut in government spending

• decline in household wealth and confidence

• higher interest rates

• fall in net exports

Why way does the curve shift if AD increases/decreases?

AD increases - outwards shift

AD decreases - inwards shift

How do you calculate net exports?

(X-M)

If AD is AD1 and it shifts outwards, what would the line be called?

AD2

If AD is AD2 and it shifts inwards, what would the line be called?

AD3 - (this would be the inside line before AD1)

What causes a change in aggregate demand?

• expectations (positive - increases consumption and investment)

• international factors - exchange rates/foreign incomes (if domestic currency depreciates, domestic goods become cheaper for foreign buyers, exports rise)

• fiscal policy - taxes/gov spending

What are household expectation and firm expectations?

Household - if they expect future higher incomes - tend to spend now - which increases consumption

Firms - if they expect higher future demand - increase investment (tech/machinery)

Examples of fiscal policies that could change AD?

Tax cuts - hugger disposable incomes - increased consumption

What are external shocks?

Unexpected events from outside the economy that has a sudden and significant impact on economic activity

Examples of external shocks that affect AD?

• a large rise in the value of the exchange rate

• a recession, slowdown or boom

• a slump in the housing market

• an event - the global financial crisis

• a large change in commodities

What are exports? (+ injection or withdrawal?)

Goods and services sold to other counties

An injection into a nations circular flow of income and spending

In the net trade balance, should exports exceed imports or the other way around?

Exports exceed imports

How does a drop in business confidence affect AD?

If confidence decreases - may invest less - AD decreases - AD shifts inwards

What did Keynes name the term he associated with business confidence?

"Animal spirits"

What does animal spirits describe?

Fluctuating confidence of investors and businesses

Which political party would Keynes be associated with?

Labour - big state