Edexcel Economics (A) A-level

Theme 2: The UK Economy -

Performance and Policies
2.2 Aggregate Demand
Summary Notes

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 2.2.1 The characteristics of AD
Components of AD and their relative importance:

Aggregate demand is the total demand in the economy. It measures spending on

goods and services by consumers, firms, the government and overseas consumers
and firms.
It is made up of the following components, which make up the equation:
C + I + G +(X-M)

o Consumer spending: This is how much consumers spend on goods and

services. This is the largest component of AD and is therefore most significant
to economic growth.
o Investment: This is business spending on capital goods. It accounts for around
15-20% of GDP in the UK per annum, and about ¾ of this comes from private
sector firms. The other ¼ is spent by the government on, for example, new
schools.
o Government spending: This is how much the government spends on state
goods and services, such as schools and the NHS. It accounts for 18-20% of
GDP. Transfer payments are not included in this figure, because no output is
derived from them, and it is simply a transfer of money from one group of
people to another.
o Exports minus imports: This is the value of the current account on the
balance of payments. A positive value indicates a surplus, whilst a negative
value indicates a deficit. The UK has a relatively large trade deficit, which
reduces the value of AD. This is the most insignificant part of AD.

Moving along the AD curve:

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A fall in the price level from P1 to P2 causes an expansion in demand from Y1 to Y2.
A rise in the price level from P2 to P1 causes a contraction in demand from Y2 to Y1.
Changes in the price level cause movements along the demand curve.

The downward slope of the AD curve can be explained by:

o Higher prices lead to a fall in the value of real incomes, so goods and services
become less affordable in real terms.
o If there was high inflation in the UK so that the average price level was high,
foreign goods would seem relatively cheaper. Therefore, there would be
more imports, so the deficit on the current account might increase, and AD
would fall.
o High inflation generally means the interest rates will be higher. This will
discourage spending, since saving becomes more attractive and borrowing
becomes expensive.

Shifting the AD curve:

The AD curve is shifted by changes in the components of AD (C, I, G or X-M):

A rise in AD is shown by a shift to the right in the demand curve (AD1  AD2).
This rise in economic growth occurs when any of the components of AD increase.

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 2.2.2 Consumption
Disposable income and its influence on consumer spending:
Consumer spending: This is how much consumers spend on goods and services. This is the
largest component of AD and is therefore most significant to economic growth. It makes up
just over 60% of GDP.

Disposable income is the amount of income consumers have left over after taxes and social
security charges have been removed. It is what consumers can choose to spend.

Consumer income might come from wages, savings, pensions, benefits and investments,
such as dividend payments.

A consumer’s marginal propensity to consume is how much a consumer changes their

spending following a change in income. Consumers on low incomes are more likely to
spend.

The relationship between savings and consumption:

A consumer’s marginal propensity to save is the proportion of each additional pound of
household income that is used for saving.

A consumer’s marginal propensity to consume added to the marginal propensity to save is

equal to 1.

Consumer income which is not spent is saved.

Influences on consumer spending:

Interest rates
o If the Monetary Policy Committee lowers interest rates, it is cheaper to
borrow and reduces the incentive to save, so spending increases. There are
time lags between the change in interest rates and the rise in consumption.
Lower interest rates also lower the cost of debt, such as mortgages. This
increases the effective disposable income of households.

Consumer confidence

o If consumers have higher confidence levels, they spend more because they
are less concerned about needing to save for future difficulties. This is
affected by anticipated income and inflation.
o If consumers fear unemployment or higher taxes, consumers may feel less
confident about the economy, so they are likely to spend less and save more.
This delays large purchases, such as houses or cars.

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Wealth effects
o In the UK, most people own their houses. This means that a rise in the price of
houses makes people feel wealthier, so they are likely to spend more. This is
the wealth effect.
o A consumer’s housing equity is the difference between the market value of a
property and how much loan is remaining to be paid. If house prices increase,
consumers experience a rise in equity, so they might be paying less on their
mortgage than the house is worth on the market. This makes consumers feel
wealthier, so they are more willing to spend.
o This can also occur with other assets, such as shares.

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 2.2.3 Investment
Distinction between gross and net investment:
Gross investment: This is the amount that a firm invests in business assets that does not
account for depreciations. A depreciation is when something starts to lose value, such as
how a car loses value the older it gets. If the depreciation in the value of the capital is
greater than the growth in gross investment, there is a decrease in the value of capital in the
economy and there is no economic growth.

Net investment: This is the actual addition to the capital stock of an economy, after
depreciations have been considered. Net investment= gross investment – depreciation.

Influences on investment:

The rate of economic growth

o If growth is high, firms will be making more revenue due to higher rates of
consumer spending. This means they have more profits available to invest.

Business expectations and confidence

o If firms expect a high rate of return, they will invest more. Firms need to be
certain about the future, otherwise they will postpone their investments.
o Also, expectations about society and politics could affect investment. For
example, if a change in government might happen, or if commodity prices are
due to rise, businesses may postpone their investment decisions.
o Keynes coined the term animal spirits when describing instincts and
emotions of human behaviour, which drives the level of confidence in an
economy.

Demand for exports

o This is related to the rate of market demand. The higher demand is, the more
likely it is that firms will invest. This is because they expect higher sales, so
they might direct capital goods into the markets where consumer demand is
increasing.

Interest rates
o Investment increases as interest rates falls. This means that the cost of
borrowing is less and the return to lending is higher.
o The higher interest rates are, the greater the opportunity cost of not saving
the money.

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 o Moreover, high interest rates might make firms expect a fall in consumer
spending, which is likely to discourage investment.

Access to credit
o If banks and lenders are unwilling to lend, such as shortly after the financial
crisis when banks became more risk averse, firms will find it harder to gain
access to credit, so it is either more expensive or not possible to gain the
funds for investment.
o Firms could use retained profits, however.
o The availability of funds is dependent on the level of saving in the economy.
The more consumers are saving, the more available fund are for lending, and
therefore for investing.

The influence of government and regulations

o The rate of corporation tax could affect investment. Lower taxes means firms
keep more profits, which could encourage investment.
o Government subsidies or tax breaks could encourage investment
o High levels of regulation would discourage investment

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 2.2.4 Government expenditure
Influences on government expenditure:

The trade cycle

o This is another term for the business cycle, which refers to the stage of
economic growth that the economy is in.
o The economy goes through periods of booms and busts.

o Real output increases when there are periods of economic growth. This is the
recovery stage.
o The boom is when economic growth is fast, and it could be inflationary or
unsustainable.
o During recessions, there real output in the economy falls, and there is negative
economic growth.
o During recessions, governments might increase spending to try and stimulate the
economy. This could involve spending on welfare payments to help people who have
lost their jobs, or cutting taxes.
o This will increase the government deficit, and they may have to finance this.
o During periods of economic growth, governments may receive more tax revenue
since consumers will be spending more and earning more. They may decide to spend
less, since the economy does not need stimulating, and fewer people will be
claiming benefits.

Fiscal policy
o Governments use fiscal policy to influence the economy. It involves changing
government spending and taxation.

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o Governments might spend on public goods and merit goods, as well as
welfare payments.
o Fiscal policy is a demand-side policy, so it works by influencing the level or
composition of AD.
o Discretionary fiscal policy is a policy which is implemented through one-off
policy changes.
o Automatic stabilisers are policies which offset fluctuations in the economy.
These include transfer payments and taxes. They are triggered without
government intervention.
o The government might use expansionary fiscal policy during periods of
economic decline. This involves increasing spending on transfer payments or
on boosting AD, or by reducing taxes.
o During periods of economic growth, governments might use contractionary
fiscal policy by decreasing expenditure on purchases and transfer payments.
Additionally, tax rates might increase. This reduces the size of the
government budget deficit.

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 2.2.5 Net trade (X-M)
Net trade- exports minus imports: This is the value of the current account on
the balance of payments. A positive value indicates a surplus, whilst a negative
value indicates a deficit. The UK has a relatively large trade deficit, which
reduces the value of AD.

The main influences on the (net) trade balances:

Real income
o During periods of economic growth, consumers have higher incomes and they
can afford to consume more. This means they are likely to import more so
there is a larger deficit on the current account.
o During periods of economic decline, real incomes fall and historically, this has
led to improvements in the UK’s current account due to fewer imports.
o Incomes have little impact on exports.

Exchange rates
o A depreciation of the pound means imports are more expensive and exports
are cheaper, so the current account trade deficit narrows as people are less
likely to buy imports and more likely to buy exports.
(SPICED- strong pound, imports cheap, exports dear)
o Depreciations make the currency relatively more competitive against other
currencies.
o However, it depends on which currency the pound depreciates against. If it is
the dollar or euro, it is likely to have a more significant effect, than a currency
which is not from one of the UK’s major trading partners.
o Moreover, the demand for UK exports has to be price elastic to lead to an
increase in exports. If demand is price inelastic, exports will not increase
significantly, and the value of exports will decrease.

State of the world economy

o A decline in economic growth in one of the UK’s export markets means there
will be a fall in exports. This is because consumer spending in those
economies will fall, due to falling real incomes.
o For example, the UK’s largest export market is the EU. If they face an
economic downturn then demand for UK goods and services will fall, since
consumers in the EU are less able to afford imports.

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Degree of protectionism
o Protectionism is the act of guarding a country’s industries from foreign
competition. It can take the form of tariffs, quotas, regulation or embargoes.
o If the UK employed several protectionist measures, then the trade deficit will
reduce. This is because the UK will be importing less due to tariffs and quotas
on imports to the UK.
o However, since protectionism leads to retaliation, exports might decrease
too, which undoes the effect of reduced imports.

Non-price factors
o The competitiveness of a country’s goods and services, which is influenced
by supply-side policies, impacts how many exports the country has.
o A country can become more competitive by being innovative, having higher
quality goods and services, good advertising and marketing, strong
customer service and operating in a niche market, having lower labour
costs, being more productive or by having better infrastructure. These
increase exports.
o Moreover, trade deals and being part of trading blocs can influence how
much a country exports. This either opens up a country to, or closes a
country from, significant export opportunities.

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