4.4.1 The AD/AS model

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    Aggregate demand – total demand in the economy. It measures spending on goods/services                               by consumers, firms, the government and overseas consumers and                                   firms.

    AD can be calculated using the following equation, which describes the components of aggregate demand:                                    C+I+G+(X-M)

     

    Consumer spending makes up 65% of AD.

    Investment makes up 15% of AD.

    Government spending makes up 20% of AD.

    EXports minus iMports (net exports) makes up the remainder of AD.

    Consumer spending

    This is the amount spent on goods and services by consumers. This spending will mainly come from their disposable income, which can be affected by external factors, as can their spending habits. Examples would be:

    • Change in interest rates
    • Change in wages
    • Change in consumer confidence
    • Unemployment
    • Tax cut/rise e.g. income tax

    The majority of these factors involve a change in income received i.e. lowered interest rates lead to lower mortgage repayments therefore more disposable income. However there is a time lag between cutting interest rates and a rise in AD. Confidence on the other hand, is dependent on the consumer’s anticipated income and anticipation.

     

    Investment

    This is the private sector spending (capital investment) affected by the following factors:

    • Rate of economic growth
    • Confidence
    • Interest rates
    • Access to credit
    • Capacity utilisation

    The rate of economic growth means that the company may have more revenue due to more consumer spending. Confidence leads to a likely return on investments which therefore increases investments. The capacity utilisation is the extent that productive capacity is used, which can affect the profit margins of the company. Access to credit e.g. from the bank allows companies to invest more.

     

    Government Spending

    This is the amount spent on goods and services e.g. NHS and schools. This is affected by:

    • Government objectives
    • Stage in the economic cycle (recession/boom)

    Depending on what the government wants i.e. if there is high inflation they will try to reduce AD in order to reduce prices. Similar things will occur in a recession as the government will try to encourage spending by reducing interest rates to boost spending.

     

    Net Exports

    Exports bring in money for the economy whilst imports take it out. Therefore, if there are more imports than exports there is a deficit, and vice versa creates a surplus. The UK has a large trade deficit, reducing the value of AD.

    • Exchange rates
    • International competitors
    • State of the global economy
    • Protectionism

    If the pound becomes stronger, it leads to more imports and less exports and a deficit. If other companies have cheaper wares, then it is likely that the UK will lose out. Also, if the countries that have the export market fall into economic downturn there is less demand for UK goods.

    These are the factors that cause shifts of the AD curve, increases cause a shift to the right whilst decreases in the factor cause a shift to the left.

     

    The LRAS curve is impacted by the following factors:

    • Changes in workforce size (migration levels, birth rate)
    • Changes in workforce quality (education
    • Technological progress
    • Changes in productivity of both labour and machines
    • Changes in producer tax and subsidies

     

    These are combined to create the AS curve that we use.

    FULL CAPACITY OUTPUT

    • This is when AS is inelastic (LRAS) and maximum potential is reached. Expansion cannot increase expansion without increasing costs.
    • The economy is working at full capacity when all resources are fully utilised and the quantity produced at this amount of production is the output level.
    • When the country is working at full capacity, there is often low unemployment, increases in AD and sustainable rates of economic growth.

     

    THE MULTIPLIER EFFECT

    The multiplier effect refers to how an initial increase in spending (AD) has a greater impact on the economy, increasing national income further than the initial amount spent.

     

    The multiplier effect occurs when there is new demand in an economy. This leads to an injection of more income into the circular flow of income, which leads to economic growth. This leads to more jobs being created, higher average incomes, more spending, and eventually, more income is created.

    If there is a lot of spare capacity, output can increase quickly at a small cost. When SRAS is elastic, it increases the effect of the multiplier. On the other hand, if SRAS is inelastic (steeper line), price will increase without much of an increase in GDP. The multiplier effect has less of an effect than the potential it had.

    How the AS/AD model sheds light on the economy as a whole

    • Can show effects of shocks to the economy i.e.: a recession happening when AD falls (part of the economic cycle)
    • Show the effect of changes in technology e.g. through an increase in AS
    • Can help predict the impact on output, unemployment and prices.

     

     

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