Aggregate demand = the total demand for the goods and services produced in an economy at a given price level and in a given time period.
AD = C+I+G+(X-M)
C = Consumer expenditure
I = Investment
G = Government spending
X = Exports
M = Imports
Consumer expenditure/consumption include demand for consumer durables, household spending accounts for 65% of aggregate demand in the UK
Investment = capital investment, working capital such as stocks of finished goods and works in progress. Capital investment account for 15-20% of GDP, majority of capital investment comes from private firms. It is volatile and unpredictable and has long term effects upon supply side.
Government spending = on state provided goods and services including public and merit goods, how much is spent by the government is determined by developments in the economy and political priorities, accounts for 20% aggregate demand. Transfer payments aren’t included in government spending.
Net exports = exports are goods and services are sold overseas are inflow of demand (injection) into circular flow and add to demand for UK products. Imports are a withdrawal of demand (leakage) from circular flow of income and spending. Goods and services come into the economy but many flows out to pay for them. Net exports reflect the effect of internal trade on the level of aggregate demand.
Trade Surplus = value of exports exceeding value of imports
Trade Deficit = value of imports exceeding the value of exports
n Consumer Confidence and expectations
n Rate of interest
n Age of population
RDI – as RDI increases we save more, as RDI increases APS increases
Gov policy – tax free savings ISA
Confidence – We save when people are uncertain about the future
Age of population – young don’t save, middle age do save, elderly dis-save
Rate of interest – as interest rates increase there is an incentive to save, target savers can decrease the amount they are saving.
Range of financial institutions – more banks the more likely we are to save
Saving schemes – may be contractual savings
Savings = any income that is not spent
APS = proportion of disposable income that is saved
Dis-save = spend more than disposable income
Target savers = people who save with a target figure in mind
Firms invest when they expect the returns on capital goods that they buy, will invest if they anticipate that spending will be profitable:
n Changes in RDI
n Expectations (speed of change of expectations = volatility in investment)
n Capacity utilisation
n Current profit levels
n Corporation tax
n Rate of interest
n Advances in technology
n Price of Capital equipment
Government spending = spending done by central and local government
n Desire to please electorate
n Attempt to correct market failure
n Level of economic activity
n War, terrorism and rising crime
n RDI abroad
n RDI at home
n Domestic price level
n Exchange rate
n Government restrictions on free trade
Relationship between AD and Price level:
There are three effects which explain why an AD curve is downward sloping:
l Wealth effects:
n Households and firms, as there is a fall in price level, the amount of goods and services that wealth can buy increase. If price level increase purchasing power decreases and causes AD to contract
l Rate of interest:
n An increase in interest rates means consumption and investment reduces because there is less RDI as there is more to pay back on loans. when price level increase they increase the rate of interest to curb spending. Interest rates and inflation have a direct relationship.
l International trade effect:
n An increase in price level in c country’s goods and services means they will be less internationally competitive, causing household and firms to buy from foreign producers
Shifts in AD curve:
l Increased optimism for the future = shift right
l A cut in income tax = shift right
l Fall in price of global shares = shift left
l Increased population = shift right
l Rise in interest rates = shift left
l Fall in exchange rates = shift right
AS = the total that producers in an economy are willing and able to supply at a given price level in a given period.
Positive relation between price level and aggregate supply (PL rises AS rises/ PL down AS down). Rising prices are a signal for businesses to expand production to meet a higher level of AD. And increase in demand should lead to an expansion of as in the economy. In the middle of the diagram, output is low and unemployment is high.
Sifts in AS curve:
Quantity and quality of labour, labour increase through immigration, increase in female workers, increase retirement age, an increase in capital goods also is included in this category. Quality of labour is done through education and training, will increase productivity, also advances in technology.
Privatisation = transfer of assets from public to private sector
Privatisation: an increase in competition as market opens to new entrants, competition = an increase in the quantity of firms as they compete for consumers. In private sector large investments are made to improve quality also invest in new technology to increase quantity supplied and quality.
Macro-economic equilibrium = when AD and AS are equal
If AD was higher than AS, lead to shortage of goods and would lead to an increase in price (much like the housing market) but would encourage firms to increase in supply as the market demand is profitable. And a firms aim is profit maximisation.
When AS exceeds AD, it causes a contraction in AS since there is no incentive to supply the market. Also resources would be wasted also known as macro dis-equilibrium.
Circular flow of income:
Circular flow of income = the movement of spending and income throughout an economy
This represents the flow of spending in and out of the economy. The economic agents are the household and firm, when injections exceeds leakages = economic growth.
The multiplier effect = the process by which any change in any component of AD results in a greater final change in RGDP
Occurs when, people spend, the expenditure gained becomes the income of those who sold the item, they spend their money = knock on effect of AD rising more than the initial amount.
Changes in AD: size of initial change, size of multiplier and the original level of economic activity.
If the economy is already operating at full employment, with no spare capacity, an increase in AD will purely be inflationary.
Changes in AS:
An increase in capacity is a waste of resources as it isn’t being utilised.
Changes in AD and AS: over time, both AS and AD increase. In most years consumption and investment increase, Aggregate Supply mainly rises due to advances in technology and improved efficiency of workers.
Aggregate supply and aggregate demand increase together without encountering inflationary pressure.
Output gap = the difference between an economy’s actual and potential GDP
Yfe = full employment output
Trend growth = the expected increase in potential output over time.
Objectives of government economic policy:
1) STEADY AND SUSTAINABLE GROWTH:
l Rise in employment
l Max tax revenue
l Rise in living standards
Government wish to achieve ‘steady and sustainable growth’ to avoid fluctuations in the economy. Steady and sustainable growth happens when AS meets AD however there is a threat to future generations; pollution, health complications, used up resources
Steady and sustainable growth = economic growth that can continue over tome and doesn’t want to endanger future generations ability to expand, productive capacity.
2)ACHIEVE HIGH EMPLOYMENT AND LOW UNEMPLOYMENT:
Full employment = a situation where those willing and able to work can find employment at the going wage.
By having high employment the government can generate higher amount of tax revenue to spend elsewhere. Also with low unemployment they don’t have to pay unemployment benefits to those that don’t or can’t find work.
3) LOW AND STABLE INFLATION (TARGET OF 2%):
l Price stability
l Interest rates and inflation have a direct relation.
Inflation = a sustained rise in the price level over a period of time.
Inflation rate = the percentage increase in price level over a period of time
Hyperinflation = inflation rates over 50%
4) ACHIEVE BALANCE OF PAYMENTS:
l In relation to imports and exports
l Where exports exceed imports = trade surplus
l Imports exceeds imports = trade deficit
BOP = a record of money flows coming in and out of a country
Current account deficit = when more money is leaving the country than entering it, as a result of sales of its exports, income and current transfers abroad being less than imports, income and current transfers going abroad.
1) ECONOMIC STABILITY
Economic stability is one of the most significant objectives. Governments want to avoid significant fluctuations in the economy. An economy that experiences periods of ‘boom and bust’ , with rapid, unstable increases in aggregate demand and then periods of falling aggregate demand are likely to suffer from periods of inflation and unemployment and will underperform in terms of economic growth.
2) REDISTRIBUTION OF INCOME:
this may be done in order to ensure everyone has access to basic necessities and/or to correct what is seen as an adequate redistribution of income. In transferring some income from the rich to the poor it will however not be keen to damage incentives. It will not want to tax workers and firms too much so that work and enterprise are discouraged. It will also not want to make state benefits so generous and that living off benefits isn’t seen to be more attractive to workers.
A short run of economic growth = and increase in RGDP
A long run of economic growth = an increase in productive capacity
Measuring economic growth by the amount of percentage change in GDP.
Use of RGDP when assessing performance of an economy, as nominal GDP can be distorted by inflation. Technology can distort RGDP.
Costs of economic growth:
l Negative externalities(pollution)
l Working hours
l Non –sustainable (threat of inflation)
l Not all benefits are divided equally
l Higher GDP per capita
l More public and merit goods
l Positive externalities
l More employment
International monetary fund = organisation that helps coordinate the international monetary system
World trade organisation = organisation to promote international free trade and rule on international dispute.
Unemployment = a situation where people are out of work but are willing and able to work
Unemployment rate = percentage of labour force that is out of work.
· Certain people are unemployed but not accounted for (redundant)
· Fraudsters (work and collect benefits)
· People are able but not willing to work
1) Labour force survey (LFS)
2) Claimant count
Not eligible for JSA (Transfer payment):
1) Made redundant
2) Partner you live with earns over a certain amount of money
l Able to capture more unemployed people that don’t claim JSA
l Suitable for international comparison as the rest of Europe use it.
l More expensive to collect
l They tends to be some sampling errors
l Cheap to administer
l Some may not be seeking work and claiming under false pretences
l Not suitable for international comparison
Causes of unemployment:
l Decrease in consumer spending
l International competition (offshoring)
l People may not want to work
Cyclical unemployment = cause by a lack of demand (recession)
Structural unemployment = decline of industry in certain areas (offshoring)
Frictional unemployment = people in between jobs, seasonal, not harmful as it usually is short lived
Consequences of unemployment:
l Lost output
l Lost tax revenue
l Government spending on benefits
l Pressure on other forms of government spending( unemployed tend to be more depressed, so NHS costs)
l Costs to the unemployed
Unemployment in a country’s trading partner is likely to reduce demand for exports. In return, this reduces a country’s AD and may cause unemployment, immigration form other countries with high and rising unemployment. This may be beneficial to an economy if they have a shortage of labour with an aging population. However this would put a burden upon a country’s housing stock.
Benefits to unemployment:
l Wage costs tend to be lower, this will reduce cost of production for firms, and will reduce cost push inflation
l Makes it easier to recruit employees – larger pool of applicants to choose from.
Diagram to show a fall in the price of labour due to an increase of unemployment.
Significance to unemployment:
l How much unemployment there is
l How long the unemployment lasts
l The type of unemployment
l Unemployment isn’t evenly borne – tends to impact young males
l Generous unemployment benefits help to reduce impact of unemployment, there is an opportunity cost associated with it.
Inflation = a sustained rise in the price level over a period of time
Inflation rate = a percentage rise in the price level over a period of time
A fall in inflation rates give the consumer more spending power. Meaning they have more disposable income. The UK target is 2%.
When people anticipate inflation, consumers panic buy, increasing AD and in return increasing the price level (causing further inflation).
Measures of inflation:
Consumer price index (CPI) allows the UK to compare its inflation rates to the rest of the EU. It forms the basis for inflation targets that the government requires the bank of England to achieve . As we can compare its known as “harmonised index of consumer prices”(HICP).
CPI is weighted in price indices. First you select a base year. The variable item being measured is given a value of 100 in the base year and others are compared to it. The ONS do this by carrying out a family expenditure survey, which involves sampling more than 6000 households. In effect a “shopping basket” is created, this is a representative sample of about 650 products. These products have weights attached to them. (if its found for instance that 10% of peoples expenditure goes on food, = 10/100 or 1/10)/ Calculation of inflation:
Retail price index (RPI), which is used to adjust pensions and other benefits to take into account of inflation.
l Started in 1996
l Excludes all housing costs (mortgage, council tax)
l Excludes road tax and TV licences
l Includes university fees and stockbroker fees
l Includes private households and foreign investors
u Used for adjusting pensions and benefits
u Started in 1947
u RPI includes housing costs
u University fees aren't included
u Based on expenditure by private households- excludes highest income and pensioner households
Mortgage interest rates aren’t included because, when the bank of England increase the interest rates to control inflation it will actually increase the measure of RDI. This doesn’t show a true reflection of an actual increase in price of goods and services. Some argue it should be included as it makes a noticeable difference to the cost of living.
Government remove the energy prices as they tend to fluctuate, so they are removed in order to identify the underlying trend.
Deflation = a sustained fall in the price level
Hyperinflation = inflation that is above 50%
Causes of inflation:
Demand pull inflation:
Demand pull inflation = increase in the price level due to an increase in aggregate demand.
Demand pull inflation is less harmful if met with supply.
Cost pull inflation:
Cost push inflation = an increase in the price level caused by an increase in the cost of production
With cost of production increasing, there is less incentive to firms to supply to the market therefore a shift left in aggregate supply.
Consequences of inflation:
l Fall in the value of money
n Each pound coin is worth less. Purchasing power falls.
l Menu cost
n The cost of changing prices in catalogues/ menu’s due to inflation.
l Shoe leather cost
n Cost in the terms of the extra time and effort involved in reducing money holdings.
l Administrative cost
n Staff time may be devoted to adjusting accounts, assessing raw material costs and negotiating unions.
l Inflationary noise
n The distortion of price signal caused by inflation
l Fiscal drag
n Peoples income being dragged into higher tax bands as a result of tax brackets not being adjusted in line with inflation.
n If firms are uncertain about what the costs will be and what prices they will receive from selling the products, they may be reluctant to invest.
l Inflation causing inflation
n If they anticipate a rise in the price level, they might go out and buy products now, increasing AD. Also if they think the cost of living is going to increaser they may ask there employer for a wage increase, if they do so, the firm may have to increase there prices and could lead to demand pull inflation.
l Loss of international competitiveness
n If the country’s inflation rate is above that of its main competitors, its goods and services are less competitive.
Significance of inflation:
Ø Depends upon the rate of inflation
Ø Whether its anticipated or not
Ø The country’s relative rate compared to other economies
Ø The type of inflation.
Balance of payment:
Balance of payments = a record of money flows coming in and out of the country
Main elements of BOP:
1. Current account is the trade in goods and services, income and transfers
2. Capital and financial accounts = the movement of direct investment
3. Net errors and omissions = added to ensure accounts are balanced
The current account receives the most media attention, as it consists of:
l Trade in goods (visible goods)
l Trade in services (invisible goods)
Trade in goods: these are visible goods that we can see and touch AKA “a visible balance” Operate in a trade in goods deficit.
Trade in service: these are intangible goods, that cant be picked up and touched e.g banking, insurance. “invisible balance”:80% of all exports in UK is trade in services.
Income: UK residence investing abroad. Any profits or dividends received are sent abroad.
Transfers: payments between governments and the flow of money.