AS Macro Revision Aggregate Demand


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AS Macro Revision Aggregate Demand

  1. 1. AS Macro Revision Aggregate Demand Spring 2014
  2. 2. We add new resources / links / articles every day to our Economics blogs Follow this link for the AS Macro Blog on Tutor2u
  3. 3. Meaning and Measurement of Aggregate Demand • Aggregate Demand (AD) = – Total level of planned real expenditure on the goods and services produced within a country • The components of aggregate demand – Household Spending (C) – Gross Fixed Capital Spending (I) – Value of Change in Stocks (inventories) – Government Consumption (G) – Exports of Goods and Services (X) – (minus) Imports of Goods and Services (M) • AD sums to GDP (expenditure based) • Changes in the level of aggregate demand are key to understanding short-term changes in an economic cycle e.g. Recession and recovery
  4. 4. The Aggregate Demand Curve (AD) General Price Level A rise in the price level causes a contraction of AD GPL2 A fall in the price level causes an expansion of AD GPL1 GPL3 AD = C+I+G+(X-M) Y2 Y1 Y3 Real GDP
  5. 5. Understanding why the AD Curve Slopes Downwards • As the price level rises, the real value of incomes fall and consumers are less able to buy what they want or Falling real need – this is known as the real balance effect incomes • A persistent rise in the price of level of Country X could make foreign-produced goods and services Balance of cheaper, causing a fall in exports and a rise in imports trade • If the price level rises, this causes inflation and an increase in the demand for money and a possible rise in interest rates which then has a deflationary effect Interest on demand rate effect
  6. 6. Shifts in the Aggregate Demand Curve (AD) AD1 – AD2: Outward shift General Price Level AD1 – AD3: Inward shift GPL1 AD3 Y3 Y1 Y2 AD1 AD2 Real GDP
  7. 7. Some Causes of Shifts in Aggregate Demand Changes to Monetary Policy • Changes in monetary policy interest rates • Change in the supply of money and credit • Change in value of a country’s exchange rate Changes to Government Fiscal Policy • Changes in direct / indirect taxes • Changes in government spending • Changes in government (fiscal) borrowing Business and Consumer confidence • Planned capital investment spending by businesses • Consumer confidence and retail spending
  8. 8. Consumer Spending (C) • Consumption is spending on consumer goods & services • The main sources of consumer income are wages, savings, investments, pensions and benefits. • In 2012 consumer spending in the UK was £927 billion out of a total GDP level of £1504 billion • Consumption is the biggest component of UK aggregate demand, in 2012 it was 61% of GDP Marginal Propensity to Consume The change in consumer spending following a change in income This is called the marginal propensity to consume (mpc) Say that someone receives extra pay of £2000 and they spend £1500 Thus the marginal propensity to consume is £1500 / £2000 = 0.75 The remainder is saved so the marginal propensity to save is 0.25
  9. 9. Factors Affecting Consumer Spending (C) Real Disposable Income Employment and Job Security (i.e. Income adjusted for inflation & after direct taxes and benefits When unemployment is falling, consum ption usually rises Household Wealth (House prices, share prices) – a rise in wealth can boost consumer demand Expectations and Sentiment The state of confidence or pessimism is known as animal spirits Market Interest Rates Interest rates affect the incentive to save and the cost of borrowing
  10. 10. Household Saving (S) • Saving is when people decide to postpone their consumption until a future time • Saving is disposable income that is not spent • There are many ways in which money can be saved ranging from accounts in bank and building society accounts to savings in pensions and the stock market • The savings ratio is the % of disposable income saved rather than spent e.g. if a person has an annual income of £25,000 and saves £2500 of this, then the savings ratio is 10% • A high savings ratio (for a given level of disposable income) lowers consumption and aggregate demand
  11. 11. Key Factors Affecting Household Saving (S) Real Interest Rate = nominal interest rate adjusted for inflation, a positive real interest rate incentivises saving Price Expectations If consumers expect prices to fall (i.e. Deflation) they may choose to save more now Availability of Credit Consumer borrowing counts of dis-saving (spending > current income) Unemployment / Job Security When unemployment is rising, many people save more as a precaution Consumer Confidence / When consumer confidence is strong, people are Expectations / Uncertainty more willing to borrow and save less Taxation of Savings Interest on many types of saving is taxed, some savings schemes are tax-free or low-tax Trust in Savings Institutions Deposit guarantees can encourage a higher level of household saving in banks Need to pay back debt Short-term saving to repay credit card bills or save for a mortgage deposit
  12. 12. We add new resources / links / articles every day to our Economics blogs Follow this link for the AS Macro Blog on Tutor2u
  13. 13. Household Savings Ratio and Unemployment The savings ratio (i.e. % of disposable income saved) has been volatile in recent years ranging from 0% to nearly 9% When unemployment is rising, we expect to see an increase in precautionary saving because of a fall in real incomes and a decline in consumer confidence
  14. 14. Macro-Economic Importance of Saving Business survival • Corporate savings provide a cushion during a recession • Business savings can be used as finance for takeovers and for capital investment projects Funding investment • Banks need deposits from which they can lend • Savings flow into pension funds – these can be reinvested in stock markets providing investment funds Buffer for consumers • Savings can smooth consumption during tough times • They allow people to reduce their debts • Saving are a key source of retirement income
  15. 15. Business Capital Investment (I) Investment (I) is spending on capital goods such as new factories & other buildings machinery, technology & vehicles • I is a component of AD, and is a factor affecting competitiveness • In market-based economies, most investment is done by private sector businesses but state (Govt) investment also important • Gross investment spending is total spending on new capital. This figure includes an estimate for the value of capital depreciation since some investment is needed each year to replace technologically obsolete or worn-out plant and machinery • If gross investment is higher than depreciation, then net investment is positive and the size of the capital stock will grow • Gross investment – capital depreciation = net investment
  16. 16. Key Factors Determining Business Investment Expectations play a key role for businesses Actual & expected demand Macroeconomic uncertainty hits planned investment Expected profits and business taxes Interest rates + availability of finance Business confidence
  17. 17. Business Investment and the Economic Cycle In normal times, an upturn in the cycle will bring about a rise in business investment. But the years 2009-2013 have been different “The economy remains a long way from a strong and sustainable recovery “(IMF, June 2013) Reasons for low investment in recent years 1. Weak business confidence 2. Low profits 3. High level of spare capacity 4. Exports hit by weak demand in overseas markets
  18. 18. Key Implications of a Rise in Business Investment A higher level of investment (I) can raise both actual and potential growth and help to control inflationary pressures Macroeconomic advantages of a higher level of investment Evaluation point Investment is an injection into the circular flow of income – it is a component of AD Some of the investment (capital) goods might be imported – a leakage from the circular flow New capital can boost productivity and creates additional capacity to supply Might be a lengthy time lag between workers getting more capital and productivity rising Creates extra demand in investment goods industries and can lead to strong multiplier effects on the level of GDP Some capital investment replaces labour and therefore might cause some short term unemployment Investment will boost a country’s competitiveness and improve the trade balance Many other factors affect competitiveness – including the level of the exchange rate
  19. 19. Economic Importance of Infrastructure Investment Spending on new sewers, roads, wind farms, telecommunications networks and ports by both the private and the public sector Examples of UK infrastructure projects • 2nd Forth Road Bridge • Cross Rail and the High Speed Rail project • London Gateway Port & new London super sewer • Nuclear power plants including Hinkley Point Economic significance of infrastructure • Potentially high multiplier effects from multibillion investment projects – boosts AD and jobs • Lack of infrastructure may discourage FDI • Increases the capital stock / productive potential
  20. 20. Exports of Goods and Services (X) Exports are goods and services sold to other countries. Exports are an injection into the circular flow of income and spending Relative Prices of exports in World Markets The Exchange Rate – stronger currency makes exports more expensive Non-Price Demand Factors e.g. Design and branding Strength of Aggregate Demand in Key Export Markets Many factors affect the level of demand for a nation’s exports – some of these are shown in the graphic on the left
  21. 21. Exports and the UK Economic Cycle In a recession we find that export sales overseas fall because of economic weakness, contracting demand in key export markets More than 50% of UK exports of goods and services are sold to fellow nations inside the EU single market The volume of exports and imports tends to vary with the economic cycle: • 2009 – a year of recession with a fall in global trade • 2014 – faster GDP growth in the UK helped by a rise in export sales
  22. 22. Get help on the AS macroeconomics course using twitter #econ2 @tutor2u_econ