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Aggregate Demand
The total demand for goods and services produced in an economy at a given price level and at given time period
Why is AD downward sloping?
- Wealth Effect
- decrease in price, consumtion increases
- if people think their assest have a high value, more confident so may consume more as if anything happens they can just sell their assets - Interest Rates
- when price increases, people need to borrow more to afford the goods
- interest rate increases, cost of borrowing increases so consumption decreases - International Trade
- a rising price level decreases international trade and competitiveness
- lower demand for net exports
Components of AD
- Consumption
- Investments
- Government Spending
- Net Exports
Determinants of consumption
- interest rates
- disposable income
- inflation
- distribution of income
- consume my welfare
- wealth
- age structure of population
Determinants of saving
- interest rates
- rise in income
- age structure
- state of financial institution
- confidence and expectations
- government policies
Marginal propensity to consume
The proportion of additional income allocated to consumption
- usually between 0 and 1
MPC
change in consumption / change in income
What does the level of consumption depend upon?
- how much consumers are taxed
- depends on MPC
- type of good
Marginal propensity to save
The proportion of additional income that is allocated to saving
MPS
change in savings / change in income
Life cycle hypothesis (Franco Modigiliani)
Individuals seek to smooth consumption over the course of a lifetime
- borrowing when low income and saving when high income
Individuals in Life Cycle Hypothesis
1. Students
- will take out student loans and so spend a lot instead of saving
2. Working aged individuals
- want to save more money to smooth consumption
- save money for mortgages and retirement
3. Retirees
- don’t need to save anymore and so spend a lot
- may sell off wealth too smooth consumption
- lots of leisure times or spend more
What else keeps consumption stable beside income?
Wealth
Limitations of the life cycle hypothesis
- irrationality
- lack of information
- present focused bias
- unwilling to run down wealth
What does the extent to which the life cycle hypothesis is plausible depend on?
1. High or Low income
- high income earners will save as they have already met their needs and once and still have money left over
- high income earners have lots of financial knowledge
- low income earners will spend more as they don’t have the privilege to save as have not met needs and wants
2. Developed or developing country
- developed countries have a welfare state and better financial institutions
- in developed countries government gives up pensions and benefits so less likely to save
- in undeveloped countries they may not have a secure government or financial institution to trust so may save at home
- dont have a welfare state in developing countries
Permanent income hypothesis (Milton Friedman)
Consumers do not make decisions based on current income only but instead permanent income
- depends on income they expect for the next few years
Why will consumption not necessarily change dramatically?
If consumers perceive changes in their income to be temporary so we’ll not change consumption patterns massively
Limitations of the permanent income hypothesis
1. Low/High income households
- if low income household gets a large summer money they have high pressure to consume more to meet needs and wants
- high income households tend to save as they can already afford and met their needs
2. Unexpected increase in windfall
- when increase in bonuses people tend to save more
3. Subjectivity
- Some people may perceive permanent and temporary income differently
Investment
The addition of capital stock of the economy
Why is investments so volatile?
Investments rely on business confidence so if firms feel more confident they are more willing to invest
Determinants of investments
- rise in disposable income
- interest rates
- level of profit
- corporation tax
- subsidies
- capacity utilization
What do firms expectations and confidence impact in an economy?
- employment
- inflation
- changes in output
What do firms consider when deciding to spend on investments?
- whether they will make a higher return from their investments
- if the Investment lowers their cost of production
What does the extent to which firms will invest depend upon?
1. Government policies
- if low tax, consumption and profit increases
- relaxed labour laws means firms can pay lower wages and have more workers
2. Means of investment
- depends on how risky the Investment is
- depends on if they have retained profit
- depends on if the bank trust the firm to give loans
3. Competitive fundamental of an industry
- depends on how many competitive firms in the industry
- depends on if they are the dominant firm in the industry
