Theme 2 - 2.2 Aggregate Demand

What is aggregate demand and how do you calculate it?

• Aggregate demand is the total level of spending in the economy at any given price

• AD = C+I+G+(X-M)

What are the components of AD?

• Consumption - consumer spending in goods and see, makes up about 60% of AD

• Investment - spending by business on capital goods (e.g - new equipment) and working capital (e.g - stocks), makes up 15%-20% and 75% of investment is by the private sector

• Government spending - spending by the government on providing goods and services, makes up 18%-20% of AD

• Net exports - exports minus imports, makes up around 5% of AD

What are the factors that affect the components of AD?

• Consumption - level of real disposable income, interest rates, consumer confidence and expectations of inflation

• Investment- interest rates, level of spare capacity (how far actual output is from maximum potential output), corporation tax, current profit levels, businesses expectations and confidence, costs and rate of economic growth

• Government expenditure - political factors (spending commitments), amount of tax revenue been raised, level of economic activity, level of borrowing government prepared to undertake

• Net exports - domestic level of real income, level of real income abroad, domestic price level, exchange rates

What is the AD curve and why does it slope downwards?

• The AD curve shows the relationship between price level and real GDP

• It slopes downwards as a rise in price is likely cause a fall in real GDP

What are the 4 key reasons for the AD curve sloping downwards

• Income effect - a rise in price is not immediate matched straight away by a rise in income so people with lower real incomes can afford to buy less

• Substitution effect - if UK prices rise, foreigners will not want to buy British exports and more British people will want to buy more foreign goods causing imports to rise and exports to decrease

• Real balance effect - a rise in prices makes savings worth less, making people save more causing a contraction in AD

• Interest rate effects - rising prices means firms need to pay workers more making a higher demand for money. If supply stays the same then the price of money “interest rates” will rise. High interest rates mean more people will save and less businesses will invest less so AD will contract.

What is disposable income?

• The money consumers have left to spend after taxes

What is the marginal propensity to consume and how do calculate it?

• It measures the proportion of addition to income that is spent on consumption

• Change in consumption / change in income

How does MPC differ?

• For the economy as a whole MPC is usually between 0 and 1

• However for poorer people it’s likely to be higher than 1 and for richer people it’s likely to be less than 1

What is the relation between savings and consumption

• An increase in consumption decreases savings so all of the factors which affect consumption which affect savings.

What are the other influences on consumer spending?

• Interest rates

• Consumer confidence

• Wealth effects - people with greater wealth tend to have greater levels of consumption - for example when real house prices increase, people feel wealthier and then spend more

• Distribution of income - higher incomes tend to save a high percentage of their income - if money moves from the rich to the poor consumption is likely to increase

• Tastes and attitude - strong materialistic drive encourages people to have the newest and the best so consumption can be very high