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What are the components of aggregate demand?
consumption, investment, government spending, net exports
What are some of the determinants of income/consumption?
- Interest rates
- Level of income
- Expected future income
- Wealth
- Consumer confidence
- The availability of credit
- Distribution of income
- Expectations of future inflation
How does interest rates influence consumption?
The rate of interest rewards savers for sacrificing current consumption, and the higher the rate of interest, the greater the reward. Thus, at any particular level of income, the amount saved will increase as the real rate of interest rises and the amount consumed will fall.
How does the level of income influence consumption?
In Keynes's view, as income rises, although absolute consumption rises, consumption falls as a fraction of total income, while the fraction saved increases. Therein lies the cause of recession, according to Keynes: too much saving and too little spending.
How does expected future income influence consumption?
People plan a large part of their savings on the basis of a long term view of their expected lifetime or permanent income. Temporary fluctuations in yearly income generally have little effect on forms of saving such as contributions of pension schemes and to the purchase of life insurance policies.
How does consumer confidence influence consumption?
The state of consumer confidence is closely linked to people's views on expected income and to changes in personal wealth. When consumer optimism increases, households generally spend more and save less, whereas a fall in optimism has the opposite effect.
How does the availability of credit influence consumption?
If credit is available easily and cheaply, consumption increases as people supplement current income by borrowing on credit created by the banking system. Conversely, a tight monetary policy reduces consumption.
How does the distribution of income influence consumption?
Rich people save a greater proportion of their income than poor people; redistribution of income from rich to poor therefore increases consumption and reduces saving.
How does expectations of future inflation?
Uncertainty caused by fears of rising inflation increases precautionary saving and reduces consumption. It may also have the opposite effect. Households may decide to bring forward consumption decisions by spending now on consumer durables, thereby avoiding future price increases
What is the difference between saving and investment?
Firms invest when they but capital goods such as machinery. However, firms also save: for example, when they store profits in a bank account without spending them
What are the two parts of a country's gross investment?
Replacement investment and net investment
What are factors that influence investment decisions?
- Rate of interest
- The relative prices of capital and labour
- The nature of technical progress
- The adequacy of financial institutions in the supply of investment funds
How does the relative prices of capital and labour influence investment?
When the price of capital rises, in the long run firms adopt more labour intensive methods of production, substituting labour for capital. A decrease in the relative prices of capital goods has the opposite effect. If the price of capital goods or interest rates falls, firms switch to capital intensive methods of production, so investment increases.
How does the nature of technical progress influence progress?
Technical progress can make machinery obsolete or out of date. When this happens, a machine's business life becomes shorter than its technical life: that is, the number of years before the machine wears out. A sudden burst of technical progress may cause firms to replace capital goods early, long before the end of the equipment's technical life.
What does the accelerator effect measure?
Measures how a change in the level of investment in new capital goods is induced by a change in national income or output
