Aggregate demand

Question 1

What is aggregate demand?

Answer 1

Aggregate demand is the total amount of planned spending on goods and services in the economy at any given price level.

Question 2

What are the four components of aggregate demand?

Answer 2

1) Consumption (C)
2) Investment (I)
3) Government spending (G)
4) Exports minus imports (x-m).

Question 3

Give two important features about the AD curve.

Answer 3

1) The diagram can be drawn as a straight line or curve.
2) Total expenditure by the economy remains much the same along the AD curve, this is called the real balance effect. This means when prices fall, people still spend approximately the same amount because they buy a higher quantity.

Question 4

When does a movement along the AD curve occur?

Give an example.

Answer 4

Movements along the AD curve occur when there is a change in the price level caused by factors unrelated to aggregated demand, i.e. changes in aggregate supply.

For example, a fall in oil prices (causing a decrease in costs of production for all firms) would result in expansion of AD and a fall in the price level.

Question 5

When does a shift in the AD curve occur?

Answer 5

A shift in the AD curve occurs when there is a change in one of the components of AD. The size of the change depends on the multiplier effect.

Question 6

What will be the effect on the price level and real output when aggregate demand increases?
What will be the effect on the price level and real output when aggregate demand decreases?

Answer 6

If aggregate demand increases, we expect the average level of prices to rise (inflation) and real output to increase (economic growth)

If aggregate demand decreases, we expect the average level of prices to fall (deflation or falling prices) and real output to decrease (slow down or depression).

Question 7

What is consumption?

What are the main determinants of consumption? (4)

Answer 7

Consumption is spending by households on goods and services, it is the main component of AD (around 65%).
The main determinants are:
1) Interest rates
2) Consumer confidence
3) Wealth effects
4) The level of employment

Question 8

How do interest rate affect consumption?

Answer 8

If interest rates rise then consumers are discouraged from spending because it costs more to borrow if spending on credit and increases the opportunity cost of spending.
Higher interest rates means that more can be earned by saving money in a bank.

Question 9

How does consumer confidence affect consumption?

Answer 9

If householders feel confident in their jobs and future prospects for the economy, they are more likely to spend on big-ticket items such as cars or expensive electrical goods.
As a result what people think is going to happen in the economy has a big effect on what actually does happen.

Question 10

How do wealth effects affect consumption?

Answer 10

An increase in share or house prices means that households are able and willing to spend more. For example people might be willing to take out a bigger loan on their house.

Question 11

How does level of employment effect consumption?

Answer 11

The higher the level of employment, the more will be spent in an economy, which might lead to even more employment.

Question 12

What is investment?

What are the 8 main determinants of investment?

Answer 12

Investment is defined as an increase in the capital stock, the determinants of investment are:

1) The rate of economic growth
2) Confidence levels
3) Interest rates
4) Animal spirits
5) Risk
6) Access to credit
7) Government decisions
8) Government bureaucracy

Question 13

Explain how the rate of economic growth affects investment.

Answer 13

If there is an increase in real GDP, then firms will need more capital to meet the increase in demand.
Increase in real GDP causes a rise in investment and a rise investment causes a rise in real GDP.

Question 14

Explain how confidence levels affect investment.

Answer 14

If business confidence is high and firms believe that they will be able to sell more in the future, they are more likely to invest.

Question 15

Explain how interest rates affect investment.

Answer 15

If interest rates rise, investment tends to fall because it costs more to borrow money in order to invest.

Question 16

Explain how animal spirits affect investment.

Answer 16

Sometimes consumers and firms do not act rationally, instead they act on gut instinct.

Question 17

Explain how risk affects investment.

Answer 17

The higher the level of risk, the lower the level of investment.

Question 18

Explain how access to credit affects investment.

Answer 18

Low interest rates do not necessarily means that all firms can borrow cheaply. Banks may not be willing to take risks in their lending.

Question 19

Explain how government decisions affect investment.

Answer 19

Changes in government decisions and rules have a significant impact on capital spending, especially if firms are forced to face fines, if they do not react. Government policy may mean changes in tax rates which directly affect firms.

Question 20

Explain how government bureaucracy affects investment.

Answer 20

Government bureaucracy is the level of government paperwork and regulation, that is required to make any business decisions. For example, relaxation of planning applications is likely to lead an increase in investment and building projects.

Question 21

Define gross investment.

Answer 21

Gross investment is the total amount of investment before any account is taken of the depreciation of assets. Capital loses value as it wears out or becomes less efficient. Much investment in technology is quickly outdated.

Question 22

Define net investment.

Answer 22

Net investment takes into account the fall of the value of capital assets. It is more useful as a sign of improvements in the prospects for the economy. It is the increase in capital less depreciation.

Question 23

What is fiscal policy?

Answer 23

Fiscal policy is the government’s position or set of decisions on government spending and taxation.

Question 24

What is a budget/fiscal deficit?

Answer 24

A budget deficit is where the government spends more than it earns, resulting in an increase in the flow of income or aggregate demand.

Question 25

What is a budget/fiscal surplus?

Answer 25

A budget surplus is where the government earns more than it spends, this will lead to a contraction of aggregate demand.

Question 26

How does government spending change in a recession and why?

How does government spending change in a boom and why?

Answer 26

The government automatically spends more money in a recession, because of an increase in the number of people eligible for out of work benefits and taxation receipts fall as workers lose their jobs and firms earn less.

The government automatically spends less in a boom, as tax receipts, wages and employment rise and government spending on benefits falls.

Question 27

What are the determinants of net exports? (5)

Answer 27

1) Real income
2) Exchange rate
3) Changes in the state of the world economy
4) Degree of protectionism
5) Non-price factors

Question 28

Explain how real income affects net exports.

Answer 28

If incomes rise in the domestic economy, then there is reduced incentive for domestic firms to export because they can sell their goods and services in the domestic economy.

Question 29

Explain how the exchange rate affects net exports.

Answer 29

If the exchange rate rises, net exports is likely to fall as exports become less competitive and imports become more competitive in the domestic economy.

Question 30

Explain how changes in the world economy affect net exports.

Answer 30

The success of economies around the world can have significant effect on UK exports, the slowdown of the eurozone has greatly reduced UK exports.

Question 31

Explain how degree of protectionism affects net exports.

Answer 31

If there are high tariffs, quotas or restrictions on trade, firms will find it difficult to export to certain countries.

Question 32

Explain how non-price factors affect net exports.

Answer 32

Demand for exports can be determined by many things other than price, such as quality of engineering, reliability of after-sales service, tariffs and transports costs.