Theme 2 Revision Notes:
Chapter 23: Characteristics of Aggregate Demand (AD)
- The AD curve is downward sloping
- A movement along the curve shows how real output will change is there is a change
in price
- A shift in the AD curve can be caused by any of the following: C, I, G, X, M
Aggregate Demand: the total of all demands or expenditures in the economy at any given
price
- National expenditure is one of three ways to calculate National Income – GDP
AD = C+I+G+(X-M)
- Consumption: Spending by households on goods and services
- Investment: The spending by firms on investment goods
- Government Spending: All expenditure by the government on all services and goods
- Exports – Imports
Aggregate Demand and the Price Level
There are several explanations for an inverse relationship between AD and the price level in
an economy:
1.Falling real incomes: As the price level rises,
the real value of people’s incomes fall and
consumers are less able to buy the items they
want or need. If over the course of a year all
prices rose by 10 per cent whilst your money
income remained the same, your real income
would have fallen by 10%
2.The balance of trade: A persistent rise in the
price of level of Country X could make foreign-
produced goods and services cheaper in price
terms, causing a fall in exports and a rise in
imports. This will lead to a reduction in net trade
and a contraction in AD
3.Interest rate effect: if the price level rises, this causes inflation and an increase in the
demand for money and a possible rise in interest rates with a deflationary effect on the
economy. This assumes that the central bank (in our case the Bank of England) is setting
interest rates in order to meet a specified inflation target.
, Changes in Expectations Current
spending is affected by anticipated
income and inflation
When confidence falls, we see
an increase in saving and
businesses postpone
investment projects because of
worries over weak demand and
lower expected profits.
Changes in Monetary Policy – i.e. a change in interest rates
If interest rates fall – this lowers the cost of borrowing and the incentive to save,
encouraging consumption & investment
There are time lags between changes in interest rates and AD
Changes in Fiscal Policy Fiscal Policy refers to changes in government spending, taxation
and borrowing
Income tax affects disposable income e.g. lower income tax raises disposable income
and should boost consumption.
A budget deficit is a net injection of aggregate demand
Economic events in the world economy International factors such as the exchange rate
and foreign income
A depreciation in a currency makes imports dearer and exports cheaper - the net
result should be that UK AD rises
An increase in overseas incomes raises demand for exports. In contrast a recession in
a major export market will lead to a fall in exports and an inward shift of aggregate
demand
Changes in household wealth
Changing share and property prices affect the level of wealth
Declining asset prices can hit confidence / a fall in expectations
Changes in the supply of credit
The availability of credit is vital for the smooth functioning of most modern
economies
Many banks and other lenders are now more reluctant to lend
, Interest rates on different loans have become more expensive
Chapter 24: Consumption
Consumption can be divided into spending on durable/non-durable goods
- The consumption function shows the relationship between consumption and its
determinants - the main being income
- Consumption is also affected by changes in interest rates, consumer confidence,
wealth, the availability of credit, inflation and the composition of households
Defining Consumption and Saving
Consumption: Total expenditure by households on goods and services over a period of time
- Goods and services can be split into durable and non-durable goods
- Durable: Goods consumed over a long period of time such as a car or TV
- Non Durable: Goods which are consumed almost immediately such as food or
washing powder
Saving: The portion of a households’ disposable income which is not spent over a period of
time
The Propensity to Consume
What matters is the rate at which consumers increase their spending as income rises. This is
called the marginal propensity to consume.
- Say that someone receives extra pay of £2000 in a year 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.
A simple rule to remember is that the marginal propensity to consumer added to the
marginal propensity to save must always equal 1.
The average propensity to consume measures the average amount spent on consumption
out of total income if total income in an economy was £100bil and spending £90bil then
average propensity to consume would be 0.9 C/Y (consumption/income)
Generally, people on lower incomes tend to have a higher propensity to spend.
- This matters when the government announces changes in taxation and the level of
welfare benefits. A fall in the marginal propensity to spend will cause a lower level of
consumption for a given level of income.
MPC + MPS =1
, Some Factors that Determine Consumer Spending
Many factors have an influence on the total level of consumer spending in an economy.
• Real incomes – if people’s money wages rise faster than prices, then real incomes will
increase and this leads to a higher level of real purchasing power
• Direct and indirect taxation – if there is a cut in direct taxation then, other factors
remaining the same, consumers will experience an increase in their disposable
income and spending power. In contrast, a hike in indirect taxes such as import
duties or VAT will cause prices to rise and real incomes to decline.
• Interest Rates – lower interest rates cuts the cost of paying the debt on a mortgage and
increases the effective disposable income of homeowners. In recent years many
central banks around the world have made deep cut in interest rates in a bid to
stimulate consumer demand. Official interest rates in the UK have been at 0.5% since
March 2009.
• Household Wealth – for example a sustained fall in house prices might cause a decline in
personal wealth and spending as homeowners have less housing equity available to
borrow. This is sometimes referred to as the negative wealth effect. Housing equity
is the difference between the market value of property and the outstanding
mortgage loan.
• Consumer Confidence – for example, fears of rising unemployment and expectations of
higher taxes will hit consumer sentiment and spending. If you don’t have enough
confidence, you are unlikely to go ahead with major purchases such as a new car or
kitchen.
• The Supply of Credit: One of the features of the credit crunch has been a slump in the
flow of credit available for many households and businesses – banks have become
less willing to lend and if they do, the rate of interest on the loan has increased. The
supply of mortgage finance has dried up and would-be homebuyers now need to
find a bigger deposit before getting a home loan.
• The Distribution of Income: Lower income families tend to have a higher propensity to
consume than better-off households (who tend to have a higher savings ratio). Thus
a redistribution of income towards poorer families may have the effect of boosting
total consumer demand.
• Demographics: The size and growth rate of a country’s population and the age structure
has a direct effect on total consumer spending. Some countries have a strongly
positive natural rate of population growth perhaps aided by net migration of labour.
An expanding population will add to demand for many different goods and services
including housing, health care and education.
Chapter 23: Characteristics of Aggregate Demand (AD)
- The AD curve is downward sloping
- A movement along the curve shows how real output will change is there is a change
in price
- A shift in the AD curve can be caused by any of the following: C, I, G, X, M
Aggregate Demand: the total of all demands or expenditures in the economy at any given
price
- National expenditure is one of three ways to calculate National Income – GDP
AD = C+I+G+(X-M)
- Consumption: Spending by households on goods and services
- Investment: The spending by firms on investment goods
- Government Spending: All expenditure by the government on all services and goods
- Exports – Imports
Aggregate Demand and the Price Level
There are several explanations for an inverse relationship between AD and the price level in
an economy:
1.Falling real incomes: As the price level rises,
the real value of people’s incomes fall and
consumers are less able to buy the items they
want or need. If over the course of a year all
prices rose by 10 per cent whilst your money
income remained the same, your real income
would have fallen by 10%
2.The balance of trade: A persistent rise in the
price of level of Country X could make foreign-
produced goods and services cheaper in price
terms, causing a fall in exports and a rise in
imports. This will lead to a reduction in net trade
and a contraction in AD
3.Interest rate effect: if the price level rises, this causes inflation and an increase in the
demand for money and a possible rise in interest rates with a deflationary effect on the
economy. This assumes that the central bank (in our case the Bank of England) is setting
interest rates in order to meet a specified inflation target.
, Changes in Expectations Current
spending is affected by anticipated
income and inflation
When confidence falls, we see
an increase in saving and
businesses postpone
investment projects because of
worries over weak demand and
lower expected profits.
Changes in Monetary Policy – i.e. a change in interest rates
If interest rates fall – this lowers the cost of borrowing and the incentive to save,
encouraging consumption & investment
There are time lags between changes in interest rates and AD
Changes in Fiscal Policy Fiscal Policy refers to changes in government spending, taxation
and borrowing
Income tax affects disposable income e.g. lower income tax raises disposable income
and should boost consumption.
A budget deficit is a net injection of aggregate demand
Economic events in the world economy International factors such as the exchange rate
and foreign income
A depreciation in a currency makes imports dearer and exports cheaper - the net
result should be that UK AD rises
An increase in overseas incomes raises demand for exports. In contrast a recession in
a major export market will lead to a fall in exports and an inward shift of aggregate
demand
Changes in household wealth
Changing share and property prices affect the level of wealth
Declining asset prices can hit confidence / a fall in expectations
Changes in the supply of credit
The availability of credit is vital for the smooth functioning of most modern
economies
Many banks and other lenders are now more reluctant to lend
, Interest rates on different loans have become more expensive
Chapter 24: Consumption
Consumption can be divided into spending on durable/non-durable goods
- The consumption function shows the relationship between consumption and its
determinants - the main being income
- Consumption is also affected by changes in interest rates, consumer confidence,
wealth, the availability of credit, inflation and the composition of households
Defining Consumption and Saving
Consumption: Total expenditure by households on goods and services over a period of time
- Goods and services can be split into durable and non-durable goods
- Durable: Goods consumed over a long period of time such as a car or TV
- Non Durable: Goods which are consumed almost immediately such as food or
washing powder
Saving: The portion of a households’ disposable income which is not spent over a period of
time
The Propensity to Consume
What matters is the rate at which consumers increase their spending as income rises. This is
called the marginal propensity to consume.
- Say that someone receives extra pay of £2000 in a year 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.
A simple rule to remember is that the marginal propensity to consumer added to the
marginal propensity to save must always equal 1.
The average propensity to consume measures the average amount spent on consumption
out of total income if total income in an economy was £100bil and spending £90bil then
average propensity to consume would be 0.9 C/Y (consumption/income)
Generally, people on lower incomes tend to have a higher propensity to spend.
- This matters when the government announces changes in taxation and the level of
welfare benefits. A fall in the marginal propensity to spend will cause a lower level of
consumption for a given level of income.
MPC + MPS =1
, Some Factors that Determine Consumer Spending
Many factors have an influence on the total level of consumer spending in an economy.
• Real incomes – if people’s money wages rise faster than prices, then real incomes will
increase and this leads to a higher level of real purchasing power
• Direct and indirect taxation – if there is a cut in direct taxation then, other factors
remaining the same, consumers will experience an increase in their disposable
income and spending power. In contrast, a hike in indirect taxes such as import
duties or VAT will cause prices to rise and real incomes to decline.
• Interest Rates – lower interest rates cuts the cost of paying the debt on a mortgage and
increases the effective disposable income of homeowners. In recent years many
central banks around the world have made deep cut in interest rates in a bid to
stimulate consumer demand. Official interest rates in the UK have been at 0.5% since
March 2009.
• Household Wealth – for example a sustained fall in house prices might cause a decline in
personal wealth and spending as homeowners have less housing equity available to
borrow. This is sometimes referred to as the negative wealth effect. Housing equity
is the difference between the market value of property and the outstanding
mortgage loan.
• Consumer Confidence – for example, fears of rising unemployment and expectations of
higher taxes will hit consumer sentiment and spending. If you don’t have enough
confidence, you are unlikely to go ahead with major purchases such as a new car or
kitchen.
• The Supply of Credit: One of the features of the credit crunch has been a slump in the
flow of credit available for many households and businesses – banks have become
less willing to lend and if they do, the rate of interest on the loan has increased. The
supply of mortgage finance has dried up and would-be homebuyers now need to
find a bigger deposit before getting a home loan.
• The Distribution of Income: Lower income families tend to have a higher propensity to
consume than better-off households (who tend to have a higher savings ratio). Thus
a redistribution of income towards poorer families may have the effect of boosting
total consumer demand.
• Demographics: The size and growth rate of a country’s population and the age structure
has a direct effect on total consumer spending. Some countries have a strongly
positive natural rate of population growth perhaps aided by net migration of labour.
An expanding population will add to demand for many different goods and services
including housing, health care and education.
