Aggregate Demand

What is the definition of AD?

Total level of planned real expenditure on the goods and services produced within a country

How is GDP different to AD?

GDP is the actual value of expenditure

What is the biggest component of AD in the UK?

Consumption

What are the axes on the AD curve diagram?

• y - inflation

• x - RNO (Real national output)

Which way does the AD curve slope?

Downwards

What does inflation cause AD to do?

Contract

What are the three reasons why AD slopes downwards?

• Falling real incomes - price level rises - real value of income falls - consumption reduces

• Balance of Trade - price level rises - imports cheaper than domestic goods - X falls M rises

• Interest rate effect - inflation increases demand for money (more money needed to buy same good) - interest rates rise - less consumption and investment

What is the most important determinant of consumption?

Disposable income

What is disposable income?

Income that households have to spend and save after paying tax and other payments (national insurance etc)

What is average propensity to consume (APC)?

Ratio of consumption to income

What is MPC?

The proportion of an increase in income spent on consumption

Why is MPC lower than APC?

• People use income to buy necessities

• Extra income is saved

What are 5 key factors affecting consumer spending?

• Real disposable income

• Employment and job security

• Household weath

• Expectations

• Market interest rates

What is the direct impact of a rise in interest rates on consumption and why?

Reduces it as:

• Cost of borrowing rises - more expensive to spend with credit and loans

• Reward for saving rises - more income saved than spent

What is an indirect impact of a rise in interest rates on consumption?

Increases as:

• Yield on financial assets rises (bonds etc) - opportunity cost of holding cash rises - demand for financial assets rises - value rises

• Owners of assets receive more income - spend more

What are 4 main factors affecting consumer confidence?

• Economic growth

• Household debt

• Unemployment

• House prices

What is saving?

Household disposable income that is not spent (deferred)

What is the savings ratio?

Percentage of disposable income saved

What proportion of UK households have no savings?

1/5

What are the 3 most important factors affecting savings?

• Income - low income households have to spend majority of income on necessities

• Taxation of savings and interest rates

• Price expectations - expected inflation reduces savings as it would lose value

What are three benefits of having savings for an economy?

• Business survival - prevent bankruptcy in a recession

• Funding investments - banks need savings to lend

• Buffer for consumers - smooth consumption

How does increased savings effect interest rates and therefore investment?

• Increased supply of loanable funds - excess supply - banks lower interest rates to make profit

• More firms can afford to take out more loans and invest in capital increasing I

What are two other benefits of savings for consumers?

• Allow people to reduce debts - pay interest - no need to take out loans in emergencies due to savings

• Key source of retirement income

What is investment (I)

Expenditure undertaken by firms to add to their capital stock

What is gross investment spending?

Total spending on new capital

What is included in this figure to account for replacements?

A value of capital depreciation - investment is needed to replace broken / outdated machinery

What is net investment?

Gross investment - capital depreciation

What happens if gross investment is higher than depreciation?

Size of capital stock grows

Where does the UK rank in terms of investment in the G7 countries?

Last

What are 4 factors that determine business investment?

• Actual and expected demand

• Expected profits and business taxes

• Interest rates

• Business confidence

Why does increased investment cause a multiplier effect?

It is an injection into the circular flow

Why might this investment cause a negative multiplier in the short term?

Capital goods might be imported - leakage from circular flow

Why might the effect of new capital on productivity not be apparent in the short run?

Time lag between workers getting more capital and productivity

What does increased investment create extra demand in?

Investment (capital) goods industries - multiplier effect

Why might capital investment cause short term unemployment?

Machinery may replace labour

How would capital investment help improve balance of trade?

Boosts countries competitiveness

What is the accelerator effect?

The relationship between planned capital investment and the rate of change of national income

What do firms do if they expect high demand to stay high while working at full capacity?

Increase spending on plant and machinery to increase supply capacity

Why does this cause an accelerator effect?

Change in demand and services causes a bigger percentage change in demand for capital goods

What are 3 examples of the accelerator effect?

• Investment in 4G mobile networks to meet household demand

• Capital investment in renewable energy

• Investment to create extra capacity in cloud services

What are two reasons why high interest rates reduce investment?

• Cost of borrowing rises - investment put off

• Opportunity cost of funding investments instead of putting profits in a high interest account

What else discourages investment?

High inflation - reduces real levels of return on investment

What is the definition of multiplier effect in terms of AD?

When the change in AD is greater tan the original change which brought it about

What are exports?

Goods and services sold abroad

What are imports?

Goods and services brought from abroad

Do high interest rates increase or decrease AD?

Decrease

What effect increases AD and what is this caused by?

Wealth effect - increase in house prices

What are three external shocks that could reduce AD?

• Recession in key trading partners

• Large increase in value of exchange rate

• Slump in housing market

What is public sector debt?

Debt owed by government and public corporations

What is private sector debt?

Debt owed by private businesses and households

What is financial debt?

Unpaid debts of banks and financial corporations

How does debt reduce consumption?

Interest payments reduce disposable income

How does financial debt impact Investment (AD)?

Banks have high debt and cant make fresh loans to borrow

What do countries with a high debt-to-GDP ratio need to avoid?

Deflation