Unit 2 - The UK economy - performance and policies
Institution
PEARSON (PEARSON)
A* Analysis and Evaluation. Revision guide for 2.2, 2.3, 2.4. Covers all this content in real depth to get you that A*
2.2:
Characteristics of AD, Consumption , Investment, Government spending, Net exports
2.3: characteristics of AS, short run AS, Long run AS
2.4 : National income, inject...
Unit 2 - The UK economy - performance and policies
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Aggregate Demand 2.2
Consumption- how much consumers spend on goods and services. Consumer income may come from wages, savings,
pension, benefit, and investments such a dividend payments
Disposable income- the amount of income consumers has left over after taxes and social security charges have been
removed, i.e. what consumer can choose to spend
The savings ratio- gives an idea of the average extent of saving for all households in an economy. It is calculated as the %
of disposable income that is saved
The pigou effect- occurs when consumers increase consumption due to an increase in the value of assets such as house
prices, shares etc. This would lead to higher output and increased employment
Marginal propensity to consume- refers to how likely an individual is to consume an extra £1 of income they receive. A
proportion of a change in income (margin) that will be spent on consumption rather than being saved.
Marginal propensity to save (MPS) - refers to the proportion of any extra income that is saved by consumers
Marginal propensity to withdraw (MPW) - a measure of how much of any extra pound earned is saved, taxed or spent
outside the economy on imports
Investment- expenditure undertaken by firms to add to the capital stock in the economy
Gross investment is the total amount that the economy spends on new capital. Spending on capital assets such as
buildings, machinery and equipment. This increases the productive capacity of the economy leading to economic growth.
This figure includes an estimate for the value of capital depreciation since some investment in needed each year just to
replace technologically obsolete or worn- out plan and machinery
Net investment- net investment = gross investment – capital depreciation. If gross investment is higher than depreciation,
then net investment will be positive. Thus meaning businesses will have a higher productive capacity and can meet rising
demand in the future.
Animal Spirits- John Maynard Keynes coined this term to refer to the collective mood of investors. When this is strong AD
increases leading to greater capital investment
The accelerator effect- this happens when an increase in national income (GDP) results in a proportionately larger rise in
capital investment spending. Often see a surge in capital spending by businesses when an economy is growing quite
strongly.
Net Trade (X-M)
Net exports- the export of goods and products means that money flows into the country; when the value of the money
flowing out the country as imports is deducted, a figure for the net export is the result
Marginal propensity to import- the amount of additional income that households spend on imports
Exchange rates- the price of one currency expressed in terms of another currency
,Government Spending- tax revenue and borrowing spent by the government for the benefit of the country’s citizens
Transfer payments- a redistribution of income and wealth made without goods or services being received in return
Automatic stabilisers- effects which help influence the path of economic growth due to cyclical changes in tax revenue and
welfare costs
Fiscal policy- government changes to spending, taxation and borrowing to manipulate the economy
The multiplier effect- when an initial injection into the economy has a bigger final impact on real GDP. An increase in
investment or other injection will lead to an even greater increase in national income.
Current expenditure- government spending on the day to day running of the country e.g. wages. An increase will see a shift
in the SRAS curve to the right
Capital expenditure- government spending on physical assets will help to develop infrastructure, allowing businesses to
operate effectively and efficiently. This will help shift the LRAS curve to the right and PPF outwards
Balanced budget- this occurs when government expenditure is equal to gov revenue through taxations
Budget deficit- where government expenditure exceeds tax rev
Budget surplus – where taxation exceeds government expenditure
, Aggregate demand- total level of planned real expenditure on goods and services procedures within
a country in a given time period= C + I + G + (X-M)
The components of aggregate demand are:
§ Household spending on goods and services (C)
§ GROSS fixed capital investment spending (I)
§ Government spending on public services (G)
§ Exports of goods and services (X)
§ (MINUS) Imports of goods and services (M)
GDP expenditure bases is the actual value of expenditure
Changes in AD are key to understanding fluctuations in a cycle e.g. recession and recovery, boom and slowdown
stages
Movements along the AD curve:
A movement along the AD curve is caused by a change in the average price level (the two have an inverse relationship),
caused by inflation or deflation.
§ It is important to distinguish between rates of change and absolute change: a fall in the amount of consumption
will reduce AD but a fall in the rate of rise of consumption means that consumption is still rising so AD will still
increase but by not as much.
§ A rise in the average price levels leads to a contraction of AD
§ A fall in the average price level leads to an extension of AD
The average price level can lead to several things:
§ Real incomes: a rise in the average price level can lead to the real value of incomes to drop
§ Balance of trade: if the average price level of a foreign country fell, domestic consumers would demand more imports,
causing a contraction in AD
§ Interest rates: if the average price level rises, there will be inflation
Downward sloping AD curve:
§ Real income effect: as price level falls, real value of income rises, consumption increases- real money balance effect
§ Balance of trade effect: a fall in the relative price level of country X could make foreign produced goods and services
more expensive, thus a rise in exports and fall in imports. Exports are an injection, not withdrawal
§ Interest rate effect: if price inflation is low this might lead to a reduction in I/R if the central bank has a given inflation
target. Lower interest rates = less incentive to save and a fall in I/R may cause the exchange rate to depreciate and
improve exports
,Shifts in the AD curve:
Main causes of shift in the demand curve:
§ Changes in real income and employment
§ Changes in gov spending, taxation and borrowing
§ Changes in monetary policy interest rates and the supply of credit
§ Changes in the external value of a country’s exchange rate
§ Changes in the rate of economic growth of trading partner nations
§ Fluctuations in consumer and business confidence
Shift in AD have both domestic and external causes
External shocks:
Events that come from outside a domestic economic
system. E.g. covid 19
AD shifts because of a change in any of the components of AD. This can be caused by changes in behaviour or changes in
government policy. E.g. changes in business confidence or taxation. If firms are more confident, more likely to borrow to
finance investment. This shift AD right and AD is now higher at every price level.
Demand ‘shocks’
§ A demand side shock is anything (positive or negative) that causes AD to change
§ Examples of a negative shock could be an interest rate rise, collapse in the housing market etc.
§ A fall in real GDP, knock on effect on confidence, leading to further falls in activity
§ The multiplier and accelerator effects could magnify the impact of any initial negative shock
§ Keynesians may suggest gov intervention would be required at this point
Some factors, for example interest rates, could cause a movement or a shift in the AD curve. When prices increase,
interest rates rise (because of the interest rate effect) and this causes a movement along the AD curve but if the
government increases the interest rate then there is a shift in the AD curve. It is important to always look at whether the
change is because of price or not.
, Factors influencing characteristics of AD:
Consumption:
§ spending on goods and services over a period of time
Factors affecting consumption:
Level of real disposable income – most imp factor in determining level of consumption. Those earning a large income
are able to spend more so MPC to increases.
Interest rates- Most major expenditures are bought on credit so therefore the interest rate will affect the cost of the
good for consumers. High interest rates also increase mortgage repayments so reduce consumption. Also, a rise in
interest rates decreases the value of shares and so people experience a negative wealth effect. A cut in I/R lowers the
cost of borrowing – more likely to spend
Consumer confidence- confident about the future and expect pay rises, then they will continue or increase their
spending. If they expect high levels of inflation in the future, they will buy now as it will be at a cheaper price, so
consumption will increase.
§ Expectations about a change in the taxation level will affect consumption: if consumers expect tax to increase
prices in the future, they will buy now whilst if they expect it to reduce prices in the future, they will delay their
purchases.
§ Similarly, expectations on interest rates will affect consumption: if consumers expect interest rates to fall they
may delay their purchases as things on credit will be cheaper.
Wealth effects: Wealth is a stock of assets. Greater wealth will improve a consumer’s confidence and thus lead to
greater spending. Greater wealth tends to have greater levels of consumption, known as the wealth effect.
§ The wealth effect is experienced when real house prices rise as owners now have more wealth so are more
confident with spending as they know that if they go into financial difficulty they could simply borrow
Distribution of income: Those on high incomes tend to save a higher percentage of their income than those on low
incomes and so a change in the distribution of money in the economy will affect the level of consumption.
Tastes and attitudes: In our modern society, there is a strong materialistic drive that encourages people to have the
newest and the best and therefore spending can be very high, in some cases even above income. If people were less
materialistic, consumption would decrease
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