Download Topic 2.2 Aggregate demand student version

Aggregate demand
Real
GDP in
the UK
“If you’re not confused, you’re not paying attention”
Anon
2.2.1 The characteristics of AD: unit content
Students should be able to:
• Define the components of aggregate demand
(C + I + G + (X – M)) and assess their relative
importance
• Draw an AD curve
• Distinguish between a movement along and a
shift
2.2.1 What is aggregate demand?
It is the sum of all the demand in an economy or it is
the total level of planned real expenditure on goods
and services produced within a country.
It consists of four key components:
1. Consumption (C) – spending by _____________
2. Investment (I) – spending by _____ on investment
goods (capital equipment e.g. ______________)
3. Government spending (G) – wages and goods
4. Exports minus imports (X – M)
AD = C + I + G + (X – M) = GDP (expenditure)
2.2.1 What is the proportion of components?
AD = C + I + G + (X – M)
2.2.1 What % were the components of
aggregate demand in 2012?
Consumption =
Investment =
Government spending =
Exports =
Imports =
2.2.1The diagram of aggregate demand
The AD curve
shows the
relationship
between the price
level and the level
of real expenditure
in the economy
Price
level
AD
0
Real output
2.2.1 Movement along the aggregate demand
curve
Price
level
2.2.1 Explanation of the AD graph
What does your AD graph show?
What is the price level?
In the UK we use the C_______ P_______ I____
What is a rise in the price level called?
Real output = real expenditure (see 2.4.1)
2.2.1 Why does the AD curve slope downwards?
Falling real incomes – as the price level rises, the
real value of incomes ____ and consumers are
____ able to buy what they want or need.
 Balance of trade – a persistent rise in the price
level of the UK makes foreign produced goods
______, causing a ___ in exports & ___ in imports
 Interest rate effect – if the price level rises, this
causes inflation and an increase in the demand for
money with a possible ____ in interest rates which
then has a _________ effect on demand.

2.2.1 Your turn:
What happens to AD if prices fall?
What happens if consumers expect prices to rise in
the future?
2.2.1 The meaning of aggregate demand
A movement along the curve will be caused
by a change in the price level
 Any other factor that changes aggregate
demand will cause the AD curve to shift. An
increase leads to a rightward shift, while a
decrease leads to a leftward shift.
Sketch this

2.2.2 Consumption (C): Unit content
Students should be able to:
• Define disposable income and explain its
influence on consumer spending
• Demonstrate an understanding of the
relationship between savings and
consumption
• Analyse other influences on consumer
spending: interest rates, consumer
confidence and wealth effects
2.2.2 Your turn!
What is real disposable income?
“Real” is income adjusted for ________ and
“disposable” is after _______
 What is its influence on consumer spending?

Keynes argued that ____ households would save
more and more. So, redistributing income from ____
to ______ households would increase spending in
the economy.
2.2.2 Propensity to consume (Keynes’ definition)
average propensity to consume – the
proportion of income that households devote to
consumption
 marginal propensity to consume – the
proportion of additional income devoted to
consumption
 E.g. if marginal propensity to consume = 0.7 then
for every additional £100 of income, £___ would be
spent and £____ would be saved.
 Note we look at the marginal propensity to
consume (MPC) and save (MPS) in 2.4.4

2.2.2 Saving
What is saving?
 Saving is when people decide to _______
consumption, it’s disposable income that isn’t
spent
 What is the savings ratio?
 The % of disposable income _____ rather than
_____
 What is the effect of a high savings ratio?
 It ________ consumption and aggregate demand.

2.2.2 Savings ratio question
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?
 Savings ratio =

2.2.2 Why might saving increase?
2.2.2 Match the factors with the descriptions
Availability of credit
Consumer confidence/expectation
Need to pay back debt
Price expectations
Real interest rate
Taxation of savings
Trust in savings institutions
Unemployment/job security
2.2.2 Factors influencing consumption

Increase in interest rates –
Wealth effect – a rise in the price level of some
assets e.g. _______________ so spending _____
 If unemployment falls then consumption _______
 Expectations of future inflation or if consumer
confidence rises then AD will too. But if inflation
rises then this will decrease the value of money and
so h’holds may save more to compensate
 If credit is easily available then AD will ______

2.2.2 The Paradox of Thrift (Keynes)
Saving is regarded as _________ because it
provides the funds to finance the capital
investment needed to promote long-term growth
 But if many people start saving more at the same
time, this causes a ______ in consumer demand
and an even deeper recession
 What might be rational and virtuous for an
individual might be damaging for the economy as
a whole

2.2.2 What do you think is the link between
saving and unemployment?
2.2.2 Why is saving important to the
macroeconomy?
2.2.3 Investment (I): Unit content
Students should be able to:
• Distinguish between gross and net
investment
• Analyse influences on investment: the rate of
economic growth; business expectations and
confidence; Keynes and ‘animal spirits’;
demand for exports; interest rates; access to
credit; the influence of government and
regulations
2.2.3 Investment
Investment is the addition to the capital stock of
the economy. So it refers to the purchase of
capital assets e.g. ______________________ etc.
which are used to ________ other goods
 In a free market or mixed economy, most
investment is done by _____ (private sector) but
state investment is also important.

2.2.3 Gross versus net investment
Gross Investment is the total amount that the
economy spends on new capital.
 Gross investment – the amount spent on capital
assets by an economy. But this figure includes an
estimate for the value of capital
depreciation since some investment is needed
each year just to replace technologically obsolete
or worn-out plant and machinery.
 Net investment - the amount spent on capital
assets minus depreciation

2.2.3 Gross versus net investment – have
a guess:

In the UK roughly what proportion of gross
investment has been due to depreciation i.e. how
much has been to replace old capital stock and
how much is new investment?
2.2.3 Net investment

If gross investment is higher than depreciation,
then net investment will be positive and this
means that businesses will have a
higher productive capacity and can meet rising
demand in the future
Gross investment – capital depreciation = net investment
2.2.3 Investment in physical capital v
human capital
Investment in physical capital is investment in
machinery etc. whereas investment in human
capital is investment in __________ and ________
workers.
 The “I” in AD refers to investment in physical
capital.

2.2.3 Factors affecting investment
 Interest
rates – the higher the rate, the
of credit – the easier it is to borrow,
the more likely it is that firms will ______
 Business confidence levels/positive expectations
if firms expect future sales/profits to improve, they
will _______. Keynes used the phrase ‘animal
spirits to describe the mood of managers and
owners of firms i.e. their confidence (or not!)
 Availability
2.2.3 Factors affecting investment
The rate of economic growth – if an economy is
growing quickly firms are ______ likely to invest
 The influence of government and regulations:
e.g. cutting corporation tax will _______
investment or guaranteeing loans made by banks
to firms for investment; removing regulation e.g.
planning permission will _______ more investment
too
 If the world economy is doing well then demand
for exports will _______ and so should
investment

2.2.3 What does investment lead to?
Remember that investment leads to an increase
in the productive capacity of the economy.
13 minute video (homework):
http://www.youtube.com/watch?v=kh-SrRkxuHo
2.2.4 Government expenditure (G): unit content
Students should be able to:
• Explain the main influences on government
expenditure: the trade cycle and fiscal
policy
2.2.4 Factors affecting government
spending

The government can manipulate the economy
through fiscal policy (expenditure and taxation!)
e.g. (see 2.6.2)
They may put pressure on banks to change the
supply of credit
 The trade cycle (business cycle) also affects
government spending (see 2.5.3)

2.2.5 Net trade (X - M): unit content
Students should be able to:
Explain the main influences on the (net) trade
balance:
1. real income
2. exchange rates
3. state of the world economy
4. degree of protectionism
5. non-price factors
2.2.5 Your turn!
What are exports?
Are exports an injection or withdrawal in the circular
flow of income? In other words are they bringing
money in or taking money out of our economy?
2.2.5 Net exports or the net trade balance
What are net exports?
2.2.5 Factors affecting exports and imports
Price: the higher the price the _____ the demand
so as costs have risen in the UK, demand has
______ for our exports
 Change in exchange rates – a strong currency
makes exports relatively __________ and imports
relatively ________. This ________ AD as value of
X falls and value of M rises. However, the price
elasticity of demand for exports and imports may
be very ______ meaning the stronger currency
worsens the current account in the short run.

2.2.5 Factors affecting exports and imports
Change in the state of the world economy – e.g.
a recession in the Eurozone may _______ demand
for exports
 Change in real income – an increase in real UK
incomes _________ our demand for imports
 Degree of protectionism – e.g. quotas or tariffs
________ demand for exports; the EU allows free
movement of goods and services
 Change in non-price factors e.g.

2.2.5 Link between exports and the economic
cycle
2.2.1 Movement along the AD curve

What does the AD curve show?

What will cause a movement along the curve?
2.2.1 Some causes of shifts of aggregate
demand
What causes a shift of the AD curve?
Changes in any relevant variable apart from the
price level
 E.g. changes in:

2.2.1 Movement versus shifts of AD
Some factors may cause a movement or a shift (e.g.
interest rates).
The key is to work out what caused the change.
If the change was because the price level changed
then there is a movement.
E.g. a rise in the price level causes a rise in interest
rates -> movement
But a rise in interest rates to slow down the
economy would lead to a shift of the AD curve