Unit 3.2(1): Variations in economic activity - aggregate demand (AD)

The level of economic activity measured by a country's real GDP is determined by the interaction

aggregate demand and aggregate supply of the whole economy.

→ Changes in aggregate demand and supply determine the economic growth rate an economy achieves.

Aggregate demand

the total expenditure(spend total) on all final goods and services produced in the economy at a given price level and at a given point in time.

Aggregate demand is made up of the following components:

AD = consumption + investment + government expenditure + exports – imports

AD = C + I + G + (X – M)

Aggregate demand curve

shows the relationship between the average price level of an economy and the demand for the real output or GDP of the economy

APL

the average price of all goods and services produced in an economy at a given point in time.

→ decrease in APL leads to increase in AD for the real output

(Inverse relationship)

SRAS

→ total quantity of goods and services that firms in the economy are willing and able to produce in the short-run at different APL

Determinants of consumption

1. Household income and consumption

Higher income - more spent

2. Interest rates

Negative relationship between consumption and IR (up, down)

• the cost of borrowing for expensive goods increases when IR rise, increasing household desire to save rather than spend

• Reward for saving increases as interests IR rise

• Cost of existing borrowing

IR DECREASE, CONSUMPTION EXPENDITURE RISE

3. Consumer confidence

→ expectations for future economic prospects will influence behaviour

4. Household indebtedness - higher value lower borrowing and consumption level

5. Wealth (the value of assets household wine) - most important house, house prices rise people feel wealthier = consumption rise

6. Inflation -

Effect 1: rising prices make consumers bring forward purchases and increase consumption (more in present not for future0

Effect 2: erodes household disposable income and causes a fall in consumption spending (necessities rise price)

Consumption expenditure

Consumption is household spending in final goods and services

Total amount of money that households spend on goods and services for their won use

How much spending to satisfy needs and wants

Investment

Investment is where resources are allocated to produce capital goods that can build up an economy's future productive capacity. It is an injection into the circular flow of income.

Types of investment

1. Fixed investment

→ plant and machinery

2. Human investment

→ resources allocated to education and training

3. Research and development

4. Social investment

→ involves allocating resources that can improve the future welfare of a country’s citizens

5. Infrastructure investment

Resource allocation to infrastructure investment

Determinants of investment

Plan in advance

Will invest in new capital because they want to increase output to meet an increase in demand - high positive income elasticity of demand (income rises the demand for a god increases a lot)

Determinants of investment

1. Business confidence

2. Availability of funds - determined by household savings (higher levels of household savings the more funds available for businesses to borrow and invest )

3. Interest rates (high reduces print stream)

4. Cooperative indebtedness

→ total value of borrowing firms currently have

→ borrow less if they have high level of debt

Types of government expenditure

Injection into the circular flow of income

1. Current expenditure - day to day running of government sector

2. Capital expenditure - investment projects financed by gov

3. Transfer expenditure - welfare payments supporting low income households (not included in AD because there is no productive return)

Determinants of government expenditure / spending

1. Fiscal policy - governments use spending and taxation to achieve macroeconomic goals like economic growth, controlling inflation, reducing unemployment

2. Taxation - money can raise through taxation (direct and indirect)

3. Borrowing - expenditure/spending > tax revenue they need to borrow money (done buy selling bonds)

4. Political objectives - affected spending levels

Net Exports (X-M) (exports - imports)

Net export value is positive means country is exporting more than is importing (+) opposite (-)

Exports

domestically produced goods and services sold in overseas markets that generate an inflow of funds into the domestic economy. They inject income into the circular flow.

Imports

goods and services produced overseas and sold in the domestic economy that generate an outflow of funds from the domestic economy. Imports are a withdrawal from the circular flow of income.

Determinants of net exports

Change if there is a change in the value of exports and imports

1. Economic growth overseas markets

→ rise in exports if rise in economic growth overseas (vice versa) - they have more income

2. Economic growth in domestic market

→ rise in economy = fall in net exports, rise i imports (vice versa)

3. Exchange rate

→ domestic exchange rate falls = more exports (cheaper for foreign firms to buy) and imports decrease cause too expensive to afford now

4. Trading strength - Some countries perform better in international markets than others

Changes in AD

Change if any of the components changes it will cause AD to shift

Factors that may cause a change in AD

1. Decrease in IR

→ fall lads to rise in consumption lower borrowing costs = rise in AD

2. Fall in business and consumer confidence

→ reduced confidence = reduced consumption = reduced investment = reduced AD

3. Increase in government expenditure

→ if gov spending increases as part of expansionary fiscal policy, this will lead to rise in AD

4. Rise in net exports

→ if countries exchange rate depreciates and it experiences a rise in expats and fall in imports = AD increases