F582

F582

1. Aggregate demand and supply and their interaction

   • The components of, and influences upon aggregate demand
     • Aggregate demand (AD) is the total demand for goods and services in an economy at a given price level and period of time.
     • AD = Consumer expenditure (C) + Investment (I) + Government spending (G) - Net exports ([Exports-Imports] X-M)
     • CONSUMER EXPENDITURE (C)
       • 1. REAL DISPOSABLE INCOME is the main influence on consumer expenditure. Proportion of income that is spent is called the average propensity to income (APC) this usually falls as disposable income increases
       • 2. The more WEALTH people have the more they tend to spend. Wealth can be spent and can be used to borrow against. It also results in greater consumer confidence as consumers feel wealthier if the value of their house rises.
       • 3. CONSUMER CONFIDENCE and EXPECTATIONS have a significant influence on consumer expenditure. If consumers are feeling optimistic about their future, expecting their job prospects to be good and their wages to be high they spend more.
       • 4. RATE OF INTEREST. Changes in the rate of interest are another important influence on consumer expenditure although they can be overshadowed by consumer confidence. Usually a fall in the rate of interest increase expenditure because it is cheaper for consumers to borrow money, it reduces the incentive to save and those who are paying interest on their mortgages or any other type of loan will have more money to spend. Some people may be worried about the future so may not spend or may expect the rate to fall further.
       • 5. AGE STRUCTURE OF POPULATION. It is generally thought that the young and old population spend a relatively high proportion of their income.
       • 6. DISTRIBUTION OF INCOME. Poor people spend less than the rich. Government measures that redistribute income from the rich to the poor are likely to increase total consumer spending
       • 7. INFLATION. If people expect prices to rise sharply in the future they may increase their spending. On the other hand if they expect prices to fall they may delay their spending.
       • 8. GOVERNMENT POLICIES. Introducing a tax-free saving scheme will encourage people to save more. In contrast a government decision to raise state pensions may reduce the incentive for people to save for retirement.
     • INVESTMENT (I)
       • 1. REAL DISPOSABLE INCOME. If real disposable income is increasing, demand for consumer goods and services is likely to be rising. May encourage firms to expand capacity, in itself however a rise in disposable income may not be sufficient to encourage firms to invest. Firms would also have to believe that the rise in demand will last.
         • 2. EXPECTATIONS. If firms feel optimistic about future economic prospects, they are much more likely to invest.
           • 3. CAPACITY UTILISATION. Firms are also more likely to invest if they are operating close to full capacity. In contrast if they have considerable spare capacity they may be able to increase output without having to buy new capital goods.
             • 4. CORPORATION TAX. Tax on firms profits, cut in corporation tax increases the amount of profit firms can keep and so can result in an increase in investment. Government can also stimulate investment by providing investment subsidies.
               • 5. RATE OF INTEREST. If the rate of interest increases investment is likely to be reduced due to the fact firms may prefer to place their money in financial institutions where there money can accrue interest. Have to pay higher rate of interest on money borrowed for investment. Change in interest rate will affect expected return on investment.
                 • 6. ADVANCES IN TECHNOLOGY. Firms may buy new capital equipment if it thinks that it will produce better quality products or cheaper products. If other firms are adopting advanced technology, a firm may be forced to follow suit just to stay competitive and maintain its profit level.
                   • 7. PRICE OF CAPITAL EQUIPMENT. Reduction in the price of capital equipment may also increase investment. A fall makes it viable for more firms to use the equipment or for those firms already using the equipment to expand their capacity.
     • GOVERNMENT SPENDING (G)
       • 1. EXTENT OF MARKET FAILURE. The extent of market failure and its ability to correct it affect government spending. In countries where there is a high level of state intervention, government spending usually forms a higher level of aggregate demand.
       • 2. LEVEL OF ECONOMIC ACTIVITY. High level of unemployment will cause the government to raise spending in a bid to increase aggregate demand and the output of the economy. However if there is high inflation the government will reduce its spending.
       • 3. PLEASING VOTERS. Pressure to spend money on improving education, healthcare and transport infrastructure.
       • 4. WAR, TORRORIST ATTACKS AND RISING CRIME OR THEIR THREAT. Increases government spending.
     • NET EXPORTS (X-M)
       • 1. REAL DISPOSABLE INCOME ABROAD. Rise in income abroad is likely to result in more exports being sold
         • 2. REAL DISPOSABLE INCOME AT HOME. Rise in income at home will reduce exports.
           • 3. DOMESTIC PRICE LEVEL. Value of exports may fall and the value of imports may rise if the domestic price level increases.
             • 4. EXCHANGE RATE. Fall in a countries exchange rate will reduce the price of exports and raise the price of imports. Rise in the exchange rate will lead to a fall in net exports.
       • 5. GOVERNMENT RESTRICTION ON FREE TRADE. Countries net exports may rise if other countries remove trade restrictions.
   • Aggregate demand
     • A change in the price level causes a movement along the aggregate demand curve. A rise in the price level decreases aggregate demand and a fall in the price level increases aggregate demand.
     • A change in any of the determinants of the components of AD will cause a shift of the AD curve. A shift to the right is an increase in AD and can be caused by: More optmistic economic concepts, a cut in income tax etc. A shift to the left is a decrease in AD and can be caused by: Fall in share prices on global market, increase in taxes etc.
     • Output: A rise in aggregate demand will increase output however a fall in aggregate demand will cause a fall in output
   • Aggregate supply
     • That factors that influence aggregate supply
       • Changes in the cost of production
       • Changes in the quantity and quality of resources
     • Output: A fall in aggregate supply will cause a fall in output, however a rise in aggregate supply will trigger a rise in output
       • Total amount that producers in an economy are willing and able to supply at a given price level in a given time period.
         • If aggregate supply shifts to the right the price level falls, however if aggregate supply shift to the right then the price level will rise
   • Market equilibrium: Where aggregate demand meets aggregate supply
   • Multiplier effect: Process by which any change in a component of aggregate demand results in a greater final change in real GDP (When injections exceed leakages)

2. Government economic policy objectives and indicators of national economic performance

   • Economic growth: In the short run, an increase in real GDP, and in the long run an increase in productive capacity (AS shifts to the right)
     • Measured by the annual percentage change in real GDP
     • Costs- May reduce quality of peoples lives (increased work loads etc..), expansion of heavy industry causes pollution
     • Benefits- Rise in standard of living, increases countries real output and can increase a countries status and power in international organisations,
     • Sustainability- Climate change and pollution
   • Unemployment: Situation where people are out of work but are willing and able to work
     • Measured using a labour force survey which is based on using the ILO definition of unemployment. Also measured through claimant count (People receiving unemployment benefits)
     • Cyclical unemployment- Rising from a lack of aggregate demand
     • Structural unemployment- Caused by the decline of certain industries and occupations due to changes in demand and supply
     • Frictional unemployment- Short term unemployment occurring when workers are in-between jobs
     • Negatives - Lost output, Lost tax revenue, Increased government spending on benefits, Costs to the unemployed, Hysterisis
     • Benefits- Disuade workers from asking for wage rises or taking industrial action
   • Inflation: A sustained rise in the price level of goods or services over a period of time in the economy
     • Main measure is consumer price index (CPI) which measures price changes of a representative basket of consumer goods and services. Differs from retail price index (RPI) in methodology and coverage.
     • Demand-pull inflation- Increases the price level caused by increases in aggregate demand
     • Cost-push inflation- Increases in the price level due to increases in the cost of production
     • Costs- Fall in the value of money, menu costs, shoeleather costs, administrative costs, inflationary noise, fiscal drag, uncertainty, loss of international competitiveness
     • Benefits- Workers like increases in pay even though it is matched with the increase in the costs of goods, may encourage firms to increase output if its demand-pull inflation
   • Balance of payments: Record of money flows coming in and out of a coutnry
     • Measured by calculating exports and imports and other sources of income and expenditure
     • Causes of a deficit- Countries expenditure abroad exceeds its revenue from abroad
     • Causes of a surplus- When a countries revenue from abroad exceeds it expenditure abroad
   • Income redistribution: Progressive tax imposed where the more money you earn the more tax you have to pay to the government
   • Economic stability: Avoid significant fluctuations in the economy, economies that fluctuate are likely to suffer from inflation and unemployment and will under perform in terms of economic growth
   • Exchange rate- Price of one currency in terms of another
     • Determined by the forces of demand and supply
     • Demand is high if- Products are internationally competitive, incomes are high abroad (buying more UK exports), rise in UK interest rates.
     • Demand is low if- Incomes rise at home (More exports are bought), speculators sell a currency
     • Export prices- Depreciation of pound will reduce price of exports
     • Imports- Depreciation of pound will increase the cost of imports
     • A lower exchange rate would boost aggregate demand due to lower prices, however will put upward pressure on inflation as the cost of raw materials will rise.
     • A rise in the exchange rate is likely to increase the current account deficit and will be deflationary reducing aggregate demand leading to a reduction in real GDP and employment

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