Chapter 17 : Aggregate demand and supply analysis

• Wealth effects

  Rise in house prices makes people feel wealthier, leading to increased spending. Rising house prices increase housing equity, making consumers feel wealthier and more willing to spend
• Aggregate demand is the total demand in the economy, measuring spending on goods and services by consumers, firms, the government, and overseas consumers and firms
• Consumer income sources

  • Wages
  • Savings
  • Pensions
  • Benefits
  • Investments (e.g., dividend payments)
• Access to credit

  Unwillingness of banks to lend makes it harder for firms to access credit, affecting investment. Availability of funds depends on the level of saving in the economy
• Business expectations and confidence:

  Firms invest more with high rate of return expectations. Uncertainty about the future may lead to postponed investments. Society, politics, and external factors can affect investment decisions
• Components of Aggregate Demand

  • Consumer spending
  • Investment
  • Government spending
  • Net exports (Exports - Imports)
• Demand for exports

  Higher market demand leads to increased investment. Firms direct capital goods to markets with increasing consumer demand
• Interest rates

  If lowered by the Monetary Policy Committee, it is cheaper to borrow, reduces the incentive to save, increases spending and investment. Lower interest rates also lower the cost of debt, increasing disposable income
• Consumer confidence

  Higher confidence leads to increased investment and spending. Fear of unemployment or higher taxes may reduce confidence, leading to less spending and more saving
• Rate of economic growth

  High growth leads to higher revenue for firms, more profits available for investment
• Consumer spending

  How much consumers spend on goods and services, the largest component of AD and significant to economic growth
• Interest rates on investment

  Investment increases as interest rates fall. Lower borrowing costs and higher returns on lending encourage investment. High interest rates may discourage investment due to increased opportunity cost
• Trade cycle


  Refers to the stage of economic growth the economy is in, going through periods of booms and busts
• Government spending accounts for 18-20% of GDP and includes spending on state goods and services like schools and the NHS
• Governments may increase spending during recessions to stimulate the economy, potentially through welfare payments or tax cuts
• The availability of funds for lending and investing is dependent on the level of saving in the economy
• During recessions, real output falls, leading to negative economic growth
• Firms could use retained profits as an alternative source of funds
• Rate of corporation tax

  Affects investment; lower taxes mean firms keep more profits, potentially encouraging investment
• Fiscal policy

  Involves changing government spending and taxation to influence the economy
• Automatic stabilisers offset fluctuations in the economy without government intervention, including transfer payments and taxes
• Real income


  During economic growth, higher consumer incomes lead to a larger deficit on the current account
• A positive value indicates a surplus, while a negative value indicates a deficit
• Fiscal policy is a demand-side policy that influences the level or composition of Aggregate Demand (AD)
• Exchange rates

  A depreciation of the pound makes imports more expensive and exports cheaper, narrowing the current account trade deficit
• Expansionary fiscal policy involves increasing spending or reducing taxes during economic decline
• Exports minus imports determine the value of the current account on the balance of payments
• Unwillingness to lend, such as shortly after the financial crisis

  Banks became more risk averse, making it harder for firms to gain access to credit, resulting in more expensive or impossible funds for investment
• More consumer saving

  More funds available for lending and investing
• Transfer payments are not included in government spending figures as they involve no output and are simply money transfers between groups
• Discretionary fiscal policy involves one-off policy changes
• During periods of economic growth, governments may receive more tax revenue and may decide to spend less if the economy doesn't need stimulation
• Contractionary fiscal policy involves decreasing spending or increasing taxes during economic growth to reduce the government budget deficit
• Real output increases during periods of economic growth, known as the recovery stage
• Depreciations make the currency

  Relatively more competitive against other currencies
• Effect of pound depreciation against different currencies

  Depreciating against the dollar or euro has a more significant effect than against a currency not from one of the UK’s major trading partners
• Shifting the AD curve

  Rise in AD is shown by a shift to the right in the demand curve (AD1 to AD2); this rise in economic growth occurs when consumers and firms have higher confidence levels, the Monetary Policy Committee lowers interest rates, taxes are lowered, government spending increases, or there is a depreciation in the currency
• Effect of higher prices on the AD curve


  Lead to a fall in the value of real incomes, making goods and services less affordable in real terms
• Changes in the price level

  Cause movements along the demand curve
• Decline in economic growth in one of the UK’s export markets

  Results in a fall in exports due to falling consumer spending and real incomes