04 aggregate demand


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04 aggregate demand

  1. 1. HOW THE ECONOMY WORKS? Aggregate Demand AGGREGATE DEMAND AGGREGATE DEMAND Aggregate demand is the total expenditure on the output of domestic firms over a specified time period, usually a year. AD consists of expenditure by households (consumption), expenditure by other firms (investment), expenditure by the government (government expenditure) and expenditure by foreigners (exports). However, it must be recognised that much as the spending of households, firms and the government is actually spent of foreign products and services. These imports have to be subtracted in order to arrive at the true level of demand for domestic output. AGGREGATE DEMAND = C + I + G + [X – M] C - CONSUMPTION I - INVESTMENT G - GOVERNMENT EXPENDITURE X - EXPORTS M - IMPORTS The level of aggregate demand in the economy is crucial as it will have an influence on all the macro economic objectives (unemployment, inflation, economic growth and the balance of payments). In order to understand what determines the overall level of AD we need to understand what determines the value of each of the four components of AD. THE AGGREGATE DEMAND CURVE AGGREGATE DEMAND CURVE The AD curve shows the relationship between AD and the general price level usually measured in terms of the consumer price index. Why does the AD curve slope downwards? There are several explanations for an inverse relationship between aggregate demand and the price level: FALLING REAL INCOMES - As the price level rises, so the real value of people’s incomes fall and consumers are then less able to afford UK produced goods and services. This is known as Pigou’s Wealth Effect. THE BALANCE OF TRADE - As the price level rises, foreign-produced goods and services become more attractive (cheaper) in price terms, causing a fall in exports and a rise in imports. This will lead 1 of 16
  2. 2. HOW THE ECONOMY WORKS? Aggregate Demand to a contraction in aggregate demand. This is known as the Mundell-Fleming exchange-rate effect. INTEREST RATE EFFECT - if in the UK the price level rises, this causes an increase in the demand for money and a consequential rise in interest rates with a deflationary effect on the entire economy. This assumes that the Bank of England is setting interest rates in order to meet a specified inflation target. This is known as the Keynes' interest rate effect. SHIFTS IN THE AGGREGATE DEMAND CURVE A change in factors affecting any one or more components of aggregate demand, households (C), firms (I), the government (G) or overseas consumers and business (X) changes planned aggregate demand and results in a shift in the AD curve. RIGHT (OUTWARD) SHIFT IN AGGREGATE DEMAND An increase in AD causing a right (outward) shift in the AD curve may be caused by any of the following: Consumption Interest Rates Technological Advance Investment Government Spending Income Unemployment Exchange Rate Inflation Exports Imports Taxation Fiscal Policy Monetary Policy Consumer Confidence Corporation Tax Up Down Up Up Up Up Down Down Down Up Down Down Expansionary Expansionary Up Down LEFT (INWARD) SHIFT IN AGGREGATE DEMAND A decrease in AD causing a left (inward) shift in the AD curve may be caused by the reverse of the list above. 2 of 16
  3. 3. HOW THE ECONOMY WORKS? Aggregate Demand CHANGES IN MONETARY AND FISCAL POLICY AND AD Changes in Monetary Policy – i.e. a change in interest rates. An expansionary monetary policy will cause an outward shift of the AD curve. If interest rates fall this lowers the cost of borrowing and the incentive to save, thereby encouraging consumption. Lower interest rates also encourage firms to borrow and invest. However there are time lags between changes in interest rates and the changes in the components of aggregate demand. Changes in Fiscal Policy One example may be that the Government may increase its expenditure e.g. financed by a higher budget deficit, this directly increases AD. Also income tax affects disposable income e.g. lower rates of income tax raise disposable income and should boost consumption. Finally an increase in transfer payments raises AD – particularly if welfare recipients spend a high percentage of the benefits they receive. CONSUMPTION CONSUMPTION Expenditure by households on the goods and services produced by firms in order to satisfy their wants. This includes demand for consumer durables and non-durable goods which are “consumed” and must be re-purchased. Household spending accounts for over 65% of aggregate demand in the UK. CONSUMER DURABLES CONSUMER NONDURABLES Goods which last a long time, i.e. longer than one year, such as cars, mobile phones etc. They yield their services over a long time. They are not used up in the act of consumption. They are often but not necessarily expensive luxuries. Goods which do not last a long period of time. They are used up in the act of consumption, e.g. food, soap etc. They are often but not necessarily necessities. DETERMINANTS OF CONSUMPTION 1. WEALTH One of the most important determinants of consumption is household wealth. Most household wealth is held in the form of housing and shares. The stock of accumulated assets owned by households WEALTH If house prices or share prices increase, this means that the value of people’s assets has risen, i.e. they are wealthier. If people feel wealthier they will spend more on consumption, this is called the wealth effect. 3 of 16
  4. 4. HOW THE ECONOMY WORKS? Aggregate Demand WEALTH EFFECT The wealth effect is an economic term, referring to an increase in spending that accompanies an increase in perceived wealth. House prices can also affect consumption through the phenomenon of Mortgage Equity Withdrawal (MEW). When house prices rise, households can borrow more money secured against the value of their house. Therefore borrowing will increase and thus consumption will increase, especially on big ticket items, expensive luxuries such as cars. MORTGAGE EQUITY WITHDRAWAL In economics, mortgage equity withdrawal (MEW) is the decision of consumers to borrow money against the real value of their houses. When house prices fall, the phenomena of Negative Equity occurs. This is where the value of ones house is worth less than the value of ones mortgage. Households in negative equity are effectively thousands of pounds in debt. This will cause them to cut back on consumption leading to increased unemployment and a general decline in consumption throughout the economy. NEGATIVE EQUITY The amount by which the market value of a property falls below the amount of the mortgage secured upon it. 2. INCOME The level of people’s income from providing factors of production to firms also determines the level of consumption. Quite simply as income (Y) rises the level of consumption will also rise. This is represented by the line C = Y on the graph below and this is what the consumption would be if households spent all of their income. However the situation is not quite this simple, people do not always spend all of there income, there is an average amount of income that is spent which is described by the Average Propensity to Consume. AVERAGE PROPENSITY TO CONSUME The proportion of total income that is spent. For example if the APC = 0.8 this means that 80% of total income is spent. The APC is found by dividing consumption by income: APC = C ÷ Y By definition there is also an average amount of income which is saved and this is described by the Average Propensity to Save. AVERAGE PROPENSITY TO SAVE The proportion of total income that is saved. 4 of 16
  5. 5. HOW THE ECONOMY WORKS? Aggregate Demand For example if APS = 0.2 this means that 20% of total income is saved. APS = S ÷ Y When added together the APC and the APS will always equal 1: APC + APS = 1 The complication in the simple model is that according to the Keynesian Consumption Function as Y rises the APS increases and the APC falls, in other words people save more and spend less, thus consumption and income are no longer in their simple straight-line relationship, although in general the relationship of an increase in income leading to an increase in consumption still holds. This can also be explained by using marginal propensities. In other words by saying that as Y rises the Marginal Propensity to Consume falls and the Marginal Propensity to Save rises. People save more and spend less of any addition income they receive as Y rises, thus consumption and income are no longer in their simple straight-line relationship. MARGINAL PROPENSITY TO CONSUME The proportion of any increase in income that is spent. For example if income increases by £100 and consumption increases by £70 as a result the MPC = 0.7 MPC = ΔC ÷ ΔY MARGINAL PROPENSITY TO CONSUME The proportion of any increase in income that is saved. For example if income increases by £100 and saving increases by £70 as a result the MPS = 0.3 MPS = ΔS ÷ ΔY When added together the MPC and the MPS will always equal 1: MPC + MPS = 1 5 of 16
  6. 6. HOW THE ECONOMY WORKS? Aggregate Demand THE KEYNESIAN CONSUMPTION FUNCTION C = f(Y) on the graph shows that as income rises, so does consumption. However the rise in consumption is less that proportional to the rise in income. Generally as incomes rise the proportion of their income that people spend goes down, whereas the proportion that they save tends to increase, i.e. as income rises, the APC falls while the APS rises. At low levels of income, people tend to consume more than they earn. This is known as dissaving and implies that people are either borrowing money or running down savings. Only at higher income levels will consumption be less than income so that saving can take place. 3. INCOME TAX If income tax rises then people’s disposable income falls and thus consumption falls. DISPOSABLE INCOME Disposable income is the income that remains after taxes have been paid and any benefits received, i.e. it is the income that you can dispose of as you choose. Disposable income is the income that remains after taxes have been paid and any benefits received, i.e. it is the income that you can dispose of as you choose. The UK tax system is known as a progressive tax system, i.e. the higher your income the greater the proportion of that income you pay in tax. Income tax: taxable bands and rates 2010/2011 Taxable Income Rate of Tax 0 - £2,440 10 per cent (starting rate for savings only) 0 - £37,400 20 per cent (basic rate) £37,401 - £150,000 40 per cent (higher rate) Over £150,000 50 per cent (additional rate) 4. UNEMPLOYMENT If unemployment falls, there are more people in the economy earning an income therefore consumption rises. 6 of 16
  7. 7. HOW THE ECONOMY WORKS? Aggregate Demand 5. SOCIAL SECURITY PAYMENTS If the government raise social security benefits (e.g. Job Seekers Allowance, pensions, child benefit, disability benefit), then this has the effect of raising their disposable income and thus increases consumption, especially on those products which people on benefits tend to buy. 6. INTEREST RATES As the interest rate rises consumption will tend to fall, particularly on expensive goods such as consumer durables. As outlined previously this is because there is more incentive to save, borrowing and buying on credit is more expensive and monthly mortgage payments increase leaving less Residual Income. All this means that consumption will fall. RESIDUAL INCOME The amount of money left over after you have paid all of your ordinary and necessary debts including the mortgage. 7. EXPECTATIONS / CONSUMER CONFIDENCE If people in the economy feel that their income and jobs are secure then they are likely to consume more. If consumers are confident about the state of the economy (e.g. they expect the economy to boom over the next few months) they will feel secure in their jobs and secure in their incomes. They are therefore much more confident about spending money and taking on extra debt as they feel that they will be able to afford to take on extra debt. They will not need to save for a rainy day since they do not perceive rainy days on the horizon. Consumers will therefore have the feel-good factor. If consumers are pessimistic about the state of the economy (e.g. they expect an economic downturn in the month ahead) they are likely to feel less secure with their jobs and income. They will save more in times ahead and be reluctant to take out new loans for fear that they will not be able to pay it back. 8. INFLATION INFLATION Inflation is a sustained increase in the general price level in goods and services. If inflation increases above its target rate (2.0%) the Bank of England may respond by increasing the interest rate, which as shown before will reduce consumption. If prices are rising faster than people’s incomes (e.g. incomes rise by 5% in money terms but inflation is at 10%), then their real income and their purchasing power will fall and thus consumption will fall. However, f prices are rising, people may bring forward their purchases, i.e. buy now before prices rise too much, and therefore inflation could cause a rise in consumption. 7 of 16
  8. 8. HOW THE ECONOMY WORKS? Aggregate Demand Inflation reduces the real value of people’s savings (i.e. a fixed amount of savings buy less). If inflation is higher than the interest rate, then people may respond by saving more to protect the real value of their saving, thus consumption falls. Inflation creates a general air of uncertainty in the economy. The future becomes far less predictable if people cannot foresee what is happening to their incomes and cost of living. People will therefore be more cautious about spending thus consumption may fall. Generally economists believe that a rise in inflation will reduce consumption. Empirical evidence suggests this belief. INVESTMENT Investment is defined as expenditure by firms on capital equipment. INVESTMENT In a wider sense it can be defined as any addition to the capital stock of the economy. Investment is sometimes referred to as "Gross Domestic Fixed Capital Formation". In an even wider sense, investment can be defined as any expenditure by firms designed to increase their productive capacity. This definition allows us to talk about "investment in human capital" and "investment in research and development". Investment in human capital - refers to expenditure on education and training. More skilled workers will be more productive workers, increasing the productive capacity of firms and the economy as a whole. HUMAN CAPITAL The talents and capabilities that individuals contribute to the process of production. Investment in research and development (R&D) - refers to expenditure on the development of new products and new methods of production. More efficient production techniques will allow firms to produce more with limited resources, thereby increasing their productive capacity and that of the economy as a whole. RESEARCH AND DEVELOPMENT The money spent my firms on trying to develop new products or processes. There is a difference between "gross investment" and "net investment". Gross investment refers to all the new investment that takes place within a year. Net investment refers to the actual increase in the capital stock of the economy once allowance has been made for depreciation (the loss of value of capital stock due to wear and tear or obsolescence). Depreciation is also known as "Capital Consumption". Net Investment = Gross Investment - Depreciation 8 of 16
  9. 9. HOW THE ECONOMY WORKS? Aggregate Demand THE ECONOMIC IMPORTANCE OF CAPITAL INVESTMENT Firms often invest in new capital goods to exploit internal economies of scale. This, together with the technological advances that are often built into new machinery is vital to improving the UK's competitiveness and to causing an outward shift in the country’s production possibility frontier. An outward shift in the production possibility frontier shows that there has been an improvement or an increase in the total stock of scarce resources available to produce goods and services. The outward shift represents an improvement in economic efficiency. Capital investment is an important source of long-term growth. In the short run, devoting more of a country’s scarce resources to the production of investment goods (a process known as capital accumulation) might require a reduction in today’s output of consumer goods and services. The reallocation of resources towards capital goods would be shown by a movement from point A to B on the production possibility frontier. But if the extra investment is successful and leads to an increase in a country’s productive capacity then the PPF can shift out and open up the potential for an increased output of consumption goods to meet people’s needs and wants. This is shown by a movement from point B on the PPF to point C which lies on the new PPF after the effects of an increase in investment. Investment is a very important component of AD. Businesses involved in developing, manufacturing, testing, distributing and marketing the capital goods themselves stand to benefit from increased orders for new plant and machinery. A rise in capital investment will therefore have important effects on both the demand and supplyside of the economy including a positive multiplier effect on national income. • • DEMAND SIDE EFFECTS: Increase spending on capital goods which increases AD in the economy. SUPPLY SIDE EFFECTS: Investment is linked to higher productivity, an expansion of a country’s productive capacity, a reduction in unit costs (e.g. through the exploitation of economies of scale) and therefore a source of an outward shift in the PPF (a outward shift in the Long Run Aggregate Supply Curve). 9 of 16
  10. 10. HOW THE ECONOMY WORKS? Aggregate Demand THE DETERMINANTS OF INVESTMENT 1. INTEREST RATE There is an inverse, or negative, relationship between the interest rate and the level of investment undertaken by firms. When the interest rate rises, investment will fall. When the interest rate falls, investment will rise. There are three key reasons for this: a) Much investment is financed through borrowing. When the interest rate rises, the cost of borrowing increases, thereby reducing the profitability of any investment. Therefore investment falls. b) If the interest rate rises, there will be fewer investment projects that yield a rate of return greater than the rate of interest that could be received from a bank. Therefore firms will decide to undertake fewer investment projects (preferring to save their money instead) and the total level of investment will fall. Another way of looking at the same issue is to realise that when the interest rate rises, the opportunity cost of using retained profits for investment projects increases. As a result, investment will fall. c) When the interest rate rises, consumption is likely to fall (see notes on consumption). Firms will therefore expect demand for their product to fall. There is no point in firms investing in increased productive capacity if any extra output is unlikely to be sold. Therefore investment will fall. 2. EXPECTATIONS/BUSINESS OPTIMISM/ ANIMAL SPIRITS If firms are optimistic about the future (e.g. they anticipate rising sales due to economic growth) they will invest more in order to ensure they have the productive capacity necessary to meet the expected increase in demand. If businesses are pessimistic about the future (e.g. they expect falling sales in an oncoming recession), they will invest less because there is no point increasing productive capacity if any increased output is going to remain unsold. 3. THE COST OF CAPITAL If capital goods (e.g. machinery) become more expensive, this reduces the profitability of any investment and therefore investment will fall. 10 of 16
  11. 11. HOW THE ECONOMY WORKS? Aggregate Demand If capital goods become cheaper, this effectively increases the profitability of any investment, therefore investment will rise. 4. COMPETITIVE PRESSURES If the industry becomes more competitive (e.g. new firms enter the industry) existing firms might have an incentive to invest more in order to develop better products at lower costs than competitors. 5. PROFITS Much investment (about 70%) is financed from firms' retained profits. Therefore, if profits rise (e.g. due to economic growth), investment is likely to rise. Also, if profitability rises, there is more of an incentive for profit-motivated firms to invest, therefore investment rises. 6. CORPORATION TAX Corporation tax is a tax on firms' profits. If the government cuts corporation tax, firms are left with more profit after tax and therefore have more funds for investment purposes. Hence investment rises. A cut in corporation tax also means that any investment becomes more profitable for firms (since they keep more of any profits they make), hence there is more of an incentive to invest. Investment will rise as a result. 7. GOVERNMENT SUBSIDIES The government can encourage investment by giving subsidies to firms to do so. They could, for example, give a grant to help cover the cost of research and development. Alternatively, instead of giving subsidies, they could achieve the same result by giving tax breaks to firms, e.g. not charging them tax on any profit that they retain for investment purposes. 8. TECHNOLOGICAL CHANGE If new technology is developed which is likely to increase productivity and reduce the cost of production, firms are likely to invest in this new technology. 9. THE RATE OF CHANGE OF NATIONAL INCOME (THE ACCELERATOR THEORY) The accelerator theory suggests that the level of investment will depend primarily on the rate of change (rather than the level) of national income/output. The following example explains why. Assume a firm producing toys needs one machine to produce £1m of output per year. (The machines last 20 years, meaning that we do not need to allow for depreciation in our example). 11 of 16
  12. 12. HOW THE ECONOMY WORKS? Aggregate Demand YEAR ANNUAL OUTPUT NUMBER OF MACHINES REQUIRED INVESTMENT IN MACHINES 1 2 3 4 5 6 £10m £10m £12m £15m £15m £14m 10 10 12 15 15 14 0 0 2 3 0 0 Initially in year 1 the firm has £10m of orders. It already has 10 machines and therefore no investment takes place. In year 2, orders remain unchanged and so again the firm has no need to invest. However, in year 3 orders increase to £12m. The firm now needs to invest in another two machines if it is to fulfil orders. Orders increase to £15m in year 4. The firm needs to purchase another 3 machines to increase its capital stock to 15 machines. In year 5, orders remain unchanged at £15m and so investment returns to zero. In year 6, orders decline to £14m. The firm has too much capital stock and therefore does not invest. In other words the investment by the firm is not dependent on its total required output but by the change in that output. There are two points to notice from this example: (a) Investment takes place only when there is a change in real spending in the economy. If there is no change in spending then there is no investment. In other words, it is not the level of income/output which determines the level of investment, but changes in income/output. (b) Any change in spending leads to a much bigger change in investment. For instance, the increase in spending of 25% in year 4 (from £12m to £15m) resulted in an increase in investment of 50% (from 2 machines to 3 machines). Hence investment spending in the economy is likely to be more volatile than spending as a whole (AD). Given that any change in the level of investment will feed through to aggregate demand and national income, the implication is that changes in investment will accelerate any economic growth or economic downturn which is already occurring in the economy. The idea that investment is determined by the rate of change of national income/output can be expressed as follows: It = k(Yt – Yt-1) It is investment in time period t, (Yt – Yt-1) is the change in income during year t and k is the accelerator coefficient or "capital-output ratio". The capital-output ratio is the amount of capital needed to produce a given quantity of goods (e.g. if £10 of capital is needed to produce £2 of goods, then the capital-output ratio is 5). Investment is the component of aggregate demand that fluctuates the most. 12 of 16
  13. 13. HOW THE ECONOMY WORKS? Aggregate Demand GOVERNMENT SPENDING GOVERNMENT SPENDING Government spending is spending by the government on goods and services. It is also known as Public Spending. Government spending can have a big influence on the level of aggregate demand in the economy. It is estimated that £681 billion will be spent in 2011 in the following areas: Health Pensions Welfare Education Defence Other 18% 18% 17% 12% 7% 29% REASON FOR GOVERNMENT SPENDING 1. PROVIDING PUBLIC AND MERIT GOODS One reason for government spending is to provide both Public and Merit goods. Both of which would be underprovided in the economy if they were not provided by the government, for example defence, education and health services. PUBLIC GOOD A public good is a good that is non-rivalrous and non-excludable, so there is no incentive for the private sector to produce or maintain the good. MERIT GOOD Merit goods are goods which would be under produced and under consumed in a free market. They are goods where social benefits outweigh private benefits. 2. REDISTRIBUTION OF INCOME AND WEALTH One aim of the social security system is to carry out a redistribution of income and to reduce income inequalities by providing a basic minimum level of income for those out of employment and income replacement for those who have recently been made redundant. The social security system also tries to provide a safety-net for those who suffer unexpected falls in income arising from unemployment, separation and bereavement. 3. REGULATION OF ECONOMIC ACTIVITIES The government intervenes via enforcement agencies to ensure that economic activities do not adversely affect the public interest. Examples include the Office of Fair Trading and the Competition Commission (formerly the Monopolies and Mergers Commission). 13 of 16
  14. 14. HOW THE ECONOMY WORKS? Aggregate Demand In recent years there has been a growth in the number of regulatory agencies established. These include the regulatory bodies set up to monitor the performance of the privatised utilities. Examples include Ofwat, Ofgem, Offer. 4. INFLUENCING RESOURCE ALLOCATION AND INDUSTRIAL EFFICIENCY This is achieved via regional policy which aims to reduce regional economic disparities within the UK. The Department of Trade & Industry implements policies to encourage the competitiveness and performance of the UK corporate sector. 5. INFLUENCING THE LEVEL OF MACROECONOMIC ACTIVITY Public spending has an important role to play in stabilising the level of aggregate demand in the economy. Increases in government spending on state provided goods and services add to total domestic demand and can have multiplier effects on the final level of equilibrium national income. DETERMINANTS OF GOVERNMENT SPENDING Government spending is essentially whatever the government chooses it to be although as you will see below there is an element of it that is automatic. There are 4 key areas of spending: Health Pensions Welfare Education Defence There is also spending on transport, law and order and debt interest due to government spending being greater than taxation. The amount of money the government will choose to spend and in what areas it wishes to spend it will depend, to a large degree, on the government political outlook. For example at the moment the Conservative/Liberal Coalition is very much looking to reduce government spending to reduce the level of National Debt after the last recession. There are three types of government spending: 1. CURRENT EXPENDITURE – the running cost of public services e.g. salaries, school heating etc. 2. CAPITAL EXPENDITURE – this is government investment in areas such as building bridges and roads etc. 3. TRANSFER PAYMENTS – this is payments of money for which no good or service is received, e.g. pensions, child benefit, unemployment benefit etc. Income is transferred from one group in society (taxpayers) to another (benefit recipients). 14 of 16
  15. 15. HOW THE ECONOMY WORKS? Aggregate Demand Government spending and fiscal policy in general can be either: Discretionary (Active) – Discretionary Fiscal policy is policy which the government undertakes deliberately in order to achieve a particular goal, e.g. increase government spending to raise AD in a recession or increasing spending on education in order to fulfil a New Labour election pledge. Automatic – Automatic Fiscal policy is where changes in G + T occur automatically with changes in the economy, e.g. spending will rise automatically during a recession when the government has to spend more on unemployment related benefits and fall automatically during a boom when unemployment falls. The rise is government spending during the recession increases AD and prevents the recession being as deep as it otherwise would have been. The fall in government spending during the boom reduces AD and therefore dampens down the boom. The effect is to smooth the economic cycle. Hence spending on unemployment benefits is an example of an Automatic Fiscal Stabiliser. NET EXPORTS Net exports (X-M) refers to the value of exports minus the value of imports. If exports are greater than imports, net exports will be positive. If imports are greater than exports, net exports will be negative. DETERMINANTS OF NET EXPORTS 1. THE EXCHANGE RATE EXCHANGE RATE The exchange rate is the price of one currency expressed in terms of another. If the exchange rate of the pound rises (appreciates) this simply means that the price of pounds has risen in terms of foreign currency. Foreigners need pounds in order to purchase British products, so if pounds are more expensive for foreigners to buy, UK products will be more expensive for foreigners to buy. British exports will fall as a result. Also, a rise in the exchange rate of the pound will reduce the price of foreign currency for British people. British people need foreign currency in order to purchase products from abroad, so if foreign currency becomes cheaper for British people to buy, foreign products will be cheaper for British people to buy. Imports into the UK will rise as a result. If exports fall and imports rise, net exports (X-M) will fall. Conversely, when the exchange rate falls, net exports will rise. 2. INFLATION Inflation is the rate at which prices, on average, are increasing each year. If inflation in the UK is higher than inflation abroad, UK goods and services become less competitive on world markets. Therefore, foreigners will buy fewer UK exports, while British people will buy more of the 15 of 16
  16. 16. HOW THE ECONOMY WORKS? Aggregate Demand foreign imports as they are now relatively cheaper. If exports fall and imports rise, net exports (XM) will fall. If inflation in the UK is lower than inflation abroad, the UK is actually becoming more competitive. Therefore, exports will rise and imports will fall, so net exports (X-M) will rise. 3. INCOMES IN THE UK (DOMESTIC INCOMES) If incomes rise in the UK (e.g. during a period of economic growth) imports will rise, for several reasons: • If incomes rise, people are likely to spend more on everything (excluding inferior goods). This will include imports, hence imports will rise. • If incomes rise, people will spend more particularly on luxuries. Luxury goods tend to be imported (e.g. German cars, Japanese technology, foreign wine). The UK has a high marginal propensity to import (i.e. a large proportion of any increase in income will be spent on imports). • When incomes rise, people spend more (i.e. consumption rises). This raises the level of AD and puts upward pressure on prices. As UK prices rise, UK products become less competitive (see point 2). Therefore imports rise and exports fall, so net exports (X-M) fall. • There is a limit to the amount the domestic economy can produce with its resources. As incomes rise and spending rises, the economy will get closer and closer to its full capacity (i.e. closer to its maximum output). Once full capacity has been reached, any further increases in demand will not be able to be met by the domestic economy, meaning that consumers are forced to buy from abroad. As a result, imports get "sucked in". When imports rise, net exports (X-M) fall. 4. FOREIGN INCOMES If incomes rise abroad, e.g. there is economic growth in the US, Europe and the Far East, foreigners are likely to buy more British goods. Hence exports rise and net exports (X-M) rise. A fall in foreign incomes will have the reverse effect. 5. BARRIERS TO TRADE - PROTECTIONISM The level of net exports can be affected by any barriers to trade that are in place. The government can impose a range of protectionist measures in order to protect domestic firms and domestic employment. Such measures include: • • • Tariffs (taxes on imports) Quotas (limits on the quantity of imports) Embargoes (complete bans on imports of particular goods or goods from particular countries) 16 of 16