a) The AD AS model

Edexcel (B) Economics A-level Theme 4: Making Markets Work

Aggregate Demand (AD): Total demand in the economy measured by the equation: C + I + G + (X - M). Each component represents:
- C: Consumer spending
- I: Investment by firms
- G: Government spending
- X - M: Net exports (Exports - Imports)

Largest component of AD, accounting for over 60% of GDP.
Disposable Income: Income left after taxes and social security. Influences how much consumers can spend. Sources include wages, savings, pensions, benefits, and dividends.

Interest Rates: Lowering interest rates makes borrowing cheaper, encouraging spending but may result in time lags in effect on AD.
Consumer Confidence: High confidence leads to increased spending; fear of unemployment or higher taxes can reduce spending.

Economic Growth: High growth leads to increased firm revenues and profits available for investment.
Business Expectations and Confidence: High expectations drive investment; uncertainty can delay decisions. Keynes's term "animal spirits" describes this emotional aspect.
Demand for Exports: Higher demand increases potential investment.
Interest Rates: Lower interest rates encourage investment by reducing borrowing costs.
Access to Credit: Difficulty in obtaining funds can hinder investment, making it dependent on saving levels in the economy.
Government Regulations: Tax policies can affect investment incentives.

Economic Growth: Spending may increase during recessions to stimulate economy, leading to a higher deficit.
Fiscal Policy: Involves adjustments in government spending and taxation to affect AD directly.

Influenced by:
- Real Income: Economic growth increases imports and current account deficit.
- Exchange Rates: A weaker pound makes exports cheaper and imports more expensive, possibly reducing the deficit.
- World Economy: Economic downturns in major export markets can reduce UK exports.
- Protectionism: Measures to protect local industries can reduce imports but may adversely affect exports.

A decrease in price levels leads to increased demand and a move down the curve, whereas an increase leads to lower demand and a move up the curve.
Horizon Factors: Inflation affects real income, altering demand for imports and consequently affecting AD levels.

Factors causing shifts in AD include changes in consumer spending patterns, investment from firms, government spending adjustments, tax changes, and currency value fluctuations.

Upward sloping, indicating that higher price levels motivate producers to increase supply.
Movements along the AS curve occur due to changes in price level only.

Cost Influences: Wage changes, commodity prices, and government regulations can shift the SRAS.
Could also be impacted by net migration affecting labor supply.

Fixed output levels; changes in AD lead to price level changes without affecting overall output.
Reflects the economy operating at full capacity.

Growth in productive capacity through technological advances, labor quality improvements, minimal government hindrance, and enhanced competition can shift LRAS rightward.

Full capacity is when all resources are utilized efficiently, often resulting in low unemployment and sustainable economic growth.

Describes how new demand leads to increased income and economic growth; one person’s spending becomes another’s income.
The size of the multiplier can vary depending on the elasticity of the SRAS.