no one else answered this one. (Chapter 12 Q & A)

21/02/2013 § Leave a comment

#4. 25 marks.

a) Identify the components of aggregate demand and briefly explain two factors which might determine each of these components.

The four components that make up aggregate demand are the same as those that make up GDP: consumption (depicted by variable C), investments (variable I), government spending (variable G), and net exports (exports = X, imports = M). A simple equation to calculate the aggregate demand would then be: AD = C + I + G + (X – M). Two factors that determine these components are wealth, and interest rates. Wealth is the total value of the accumulated assets owned by an individual or household. Interest rates are the opportunity cost of spending money, wherein the borrower always pays beyond the set price. We can use the inverse relationships of the wealth effect and the interest rate effect to explain these. Whenever price levels are high, obviously the public would feel poor and are discouraged to spend anything, therefore the quantity demanded will decrease (shift to the left). Likewise, if the price levels are low, the public feels richer and would then spend more, shifting the demand curve to the right. Similarly, when interest rates are high, borrowers find the values unattractive and too much, and wouldn’t invest, therefore the demand for the good decreases, shifting the curve to the left. When interest rates are low, borrowers find the values more attractive and the quantity demanded increases, shifting the demand curve to the right.

b) Evaluate the likely impact on an economy of a substantial rise in the level of savings among the nation’s households.

Households’ savings count as supply. If a nation’s households start to save more, it would have a negative impact on the economy. We know from the circular flow model that in the banking sector of a nation, savings count as leakages into the economy, which is a loss of money. Clearly then, when households save more than they invest, more money will lie stagnant and not in use, which is unhelpful for the economy, slowing or stopping the flow. Japan does this very well, but it shouldn’t. The government tries to plug money into the economy to get more of a flow going but the tradition in Japan has always been to save instead of to buy or try new things and because of this, the money that the government once subsidized for the entire nation of Japan (it was a really expensive plan) ended up in everyone’s bank accounts or in their pockets and not to firms’ goods and services. On the other hand, it the banks start to receive all the money that households are saving and putting into their banks, they would be able to lend more to the borrowers who need it. If they have a bigger supply, this might mean that banks would raise their interest rates in order to make more out of their borrowers. Savings would then have a positive impact on a nation’s banks.

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