Aggregate Demand, Fiscal Policy, Supply side policy, consumption, investment, balance of payments

AGGREGATE DEMAND 

Aggregate demand (AD) = total spending on goods and servicesAggregate demand is the same as GDP AD = C + I  + G + (X-M) Consumption  - Consumer expenditure on goods and services. Includes demand for durables. Makes up 60%Investment - Spending on capital goods such as plants and equipment by businesses and the government to produce consumer goods in the future. At 15%Government spending - Spending on state provided goods such as public goods and merit goods. Includes goods and services as well as transfer payments (benefits such as JSA and pensions). Makes up 25%Exports of goods and services - Are an injection to the circular flowImports of goods and services - Are a leakage from the circular flow (Exports - Imports) is the Net exports. Make up 1%          Exports > imports means trade surplus          Exports < imports mean trade deficit 

CONSUMPTION

Consumption is spending by households on goods and services which comes from income such as wages, savings, investment, pensions and transfer payments (benefits) It makes up 60% of AD Disposable income is the household income after the deduction of taxes and addition of welfare benefits The rate at which someone increases their spending as income rises is the marginal propensity to consume (MPC)The money that is saved (or not spent) after a change in income is the marginal propensity to save (MPS) MPC + MPS = 1 People on low incomes spend more (higher MPC) as they need to spend more disposable income on normal goods. 

What affects consumption?  Real incomes - Real incomes will increase leading to more purchasing power.  Taxation - Cut in direct taxes means more Yd and so more spending as it takes up less.  Cut in indirect taxes means VAT is lower so purchasing power will increase Interest rates - low interest rates means less is paid back on loans and so consumption will increase Household wealth - (wealth effect) decrease in house prices causes negative equity and so decrease in consumption  Consumer confidence - fears of unemployment and higher taxes will cause less consumer spending. After 2008 financial crisis, spending decreased. This is known as animal spirits (factors that affect planned spending, savings and investment)  Supply of credit - banks are less willing to lend and interest rates on loan has increased.  Distribution of income - Lower income means higher MPC compared to upper class families 

CAPTIAL INVESTMENT

Investment is spending on capital goods such as new factories & other buildings machinery and vehicles Increases competitiveness as increase in I > decrease in costs of production > decrease in cost per unit > decrease in price for consumer > increase in demand (depends on PED) due to price mechanismGross investment spending is total investment on new capital inputs. It is the total amount that the economy spends on new capital Net investment is gross investment adjusted for capital consumption. Some new investment needed each year to replace worn out machinery. Rise in capital spending will have a positive multiplier effect as increased spending on capital goods > increase in demand for industries that manufacture technology / hardware / construction

Advantages of investment  Injection into the circular flow of income. Boost productivity and creates additional capacity to supply. Creates extra demand in investment goods industries leading to growth of GDP. Boosts competitiveness (see left). Disadvantages (evaluation)  Some capital goods may have been imported (leakage) Time lag between workers getting more capital and productivity rising.  Capital investment could reduce labour causing unemployment.  Other factors can affect competitiveness. 

GOVERNMENT SPENDING 

Government spending makes up 25% of ADThere are two main types of government spending  Fiscal policy  Supply-side policy 

FISCAL POLICY 

Fiscal policy involves using government spending, taxation and borrowing to affect the level of aggregate demand, output and jobs. It is seen as an instrument of demand management (so can be used counter cyclically to smooth out volatility) Can also be used to redistribute income and wealth, correct free market failure. Expansionary fiscal policy - transmission mechanismCut in personal income taxes > boost to Yd > adds to consumer demand Cut in indirect taxes > lower prices > adds to consumer demand Cut in corporation tax > higher 'post tax' profits for businesses > adds to business capital spendingCut in tax on interest from savings > boots to Yd of people with savings > adds to consumer demand Contractionary fiscal policy  Cut in government expenditure  Increase in direct/indirect taxes Tries to reduce budget deficit 

Government spending includes: Transfer of payments - welfare payments made available through social security system .e.g. JSA, state pension. Are used to provide a basic floor of income or minimum standard of living. Current government spending - spending on state provided goods and services that are provided for on a current basis. e.g. salaries paid to people working in the NHS  Capital spending - includes spending on infrastructure such as new motorways and roads Reasons for govt. spending: Provide public goods and merit goods Provide safety net system of welfare benefits Provide necessary infrastructure Manage level of growth & AD Promote equity   

FISCAL POLICY CONT. 

There are two main types of taxation - direct and indirectDirect taxation is levied on income, wealth and profit. i.e. income tax, corporation tax. The burden cannot be passed on. Indirect taxation are taxes on spending. i.e. excise duties on fuel, VAT. Producers may be able to pass this onto consumers depending on the PED of the good. Progressive tax - the marginal rate of tax rises as income rises e.g. income tax, corporation taxProportional tax - marginal rate is constant e.g. National Insurance contributionsRegressive tax -  the rate of tax falls as income rises e.g. excise duties of items such as cigarettes and alcohol as they form a higher percentage of Yd Some could argue that a lower tax society stimulates work incentives and productivity, creates more jobs as businesses have less tax to pay and encourages a flow of FDI Some could also argue that taxation is needed to fund public services and needed for the final distribution of income and wealth

A budget deficit is when total government expenditure exceeds total tax revenue. They borrow this money from Treasury bills and bonds.Most of the government debt is bought up by financial institutionsBudget balance is difference between tax rev. and govt. spendingGross govt. debt is total debt owned by the government (national debt)  Disadvantages of a budget deficit  Higher interest rates to attract sufficient buyers of debt, which can lead to a debt trap (must borrow more to pay interest on borrowing) Opportunity cost as interest payments can be used in better ways Crowding out as high IRs has negative effect on consumption and investment  Risk of capital flight 

SUPPLY SIDE POLICIES

Supply side policies are aimed at making markets and industries operate more efficiently and contribute to a faster underlying growth of real national output. They shift the LRAS curve to the right leading to a rise in potential real output, leading to growth without inflation. However a high level of AD is needed so that the productive capacity is brought into play  Market based supply side policies include Lower business takes to stimulate investment Reducing red tape to cut the costs of doing business Tax incentives and welfare reforms causing more people to work Nationalising key industries Management of exchange rate Product market reforms - all types of goods are made and traded to increase competition and efficiencyPrivatisation - transferred from the private to the public sector to break up monopolies i.e. British Gas, British Airways 

Deregulation is the opening up of markets to greater competition to expand market supply and increase choice e.g. urban bus transport. Commitment to free trade creates competition Capital spending increases AD and increases competitiveness Supply side policies for the Labour Market These will increase quality and quantity of labour by making the British labour market more flexible to cut structural unemployment  Trade union reforms Income tax reforms and increasing incentive to work Showing the effects of supply side improvements  Apprenticeships / increase in education 

BALANCE OF PAYMENTS (X-M) 

Exports - Imports makes up 1% of GDP and is also known as the Balance of Payments (the financial transactions made between businesses and government in one country with other nations) Inflows of foreign currency = positive entry (exports)Outflows of foreign currency = negative entry (imports) The current account measures the balance of trade in goods (e.g. manufactured goods and raw materials) and services (e.g. banking and research) plus net investment incomes from overseas assets and net transfers. The UK currently has a BofP deficit meaning that the UK is not paying its way into the global economy and there is a net outflow of demand from the circular flow of income and spending. Causes of a BofP deficit are:  Poor price and non-price competitiveness e.g. higher inflation than a nation's main trading partners Strong exchange rate (see right)  Recession in other trading countries e.g. Eurozone crisis Volatile global prices

How to improve BofP deficitDemand management - tightening of fiscal and monetary policy to reduce spending leading to fall in M Supply side policies - increasing labour productivity, increase start-up companies, increasing competitiveness as this will reduce costs Protectionist measures - import quotas, tariffs. However this cannot happen as the UK has global trade agreements. Currency adjustment - the currency adjusts when there is a large trade surplus  Appreciation of currency > Rise in external purchasing power > Cheaper to import goods and services > So rising demand for imports > Worsening of trade balance > Fall in AD Depreciation of currency > Pound is cheaper overseas > Cheaper to buy British goods > Increase in demand for exports > So trade balance gets better > Increase in AD 

SHIFTS TO AGGREGATE DEMAND 

Causes of shifts in Aggregate Demand:  Fall in exports (left) Cut in govt. spending (left) Higher interest rates (left) Decline in household wealth (left)  Depreciation of the exchange rate (right)  Cuts in direct and indirect taxes (right)  Increase in house prices (right)  Expansion of supply of credit + lower IRs (right) 

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