Consumption (C)

Definition= The final purchase of goods and services

Depends on a variety of factors:

1) Current Income (positive relationship)

Income increases=C increases

2) Past and Expected future incomes (Milton Friedman's Permanent Income Hypothesis)

Modiglani's Life Cycle Hypothesis argues that consumption is related to expected lifetime earnings and is more influenced by age.

3) Prices 

Price Level (PL) increases= C increases (no choice)
Expectations of a sudden rise in PL= large increase in C 

4) Income distribution

Rich people have the choice of saving or consuming therefore if taxes (T) increase they increase their saving (S)

5) Social attitudes 

You are what you spend

6) Cost and availability of credit

Interest rates increase= C decreases 
Cost of borrowing goes up= purchasing prices increase=consumption decreases
Cost of servicing loans increase=decreased consumption 
Lack of availability= decreased C

7) Wealth effect

When house prices increase or stock markets increase, consumer confidence goes up therefore consumption increases 
Equity withdrawal

8) Saving

9) Consumer confidence (out of 100 how many happy)

Influenced by:

• unemployment 
• house prices 
• political situation
• overseas
• stock markets

Measured by: GfK

National Income (Y)

Definition= Is the total money value of goods and services produced in a given time by factors in the ownership of that country

National Income=National Output=National Expenditure (most reliable)

Therefore it can be calculated in three ways which are defined to be equal. Residual errors are added to the output and income measures to equate them to the expenditure, an average can often be taken.

Circular flow of income model:



National income statistics are used mainly as a measure of economic welfare but are also a useful source of information on different sectors of the economy.

Problems when using National Income statistics:

1. When giving changes in the value of money use real values rather than nominal values (GDP deflator rather than RPI is used)
2. When comparing living standards use per capita rather than total national income figures
3. Two countries with the same per capita national income, may differ considerably in living standards if income distribution is different
4. The composition of national income will affect living standards (e.g. consumption v investment)
5. Statistics are often unreliable (Black markets in the UK)
6. National income statistics exclude households (the non-market sector) which varies in size over time and between countries (e.g Kenya, has a very large non-market sector, this is misleading in living standards nominally)
7. International comparisons are complicated due to different currencies and using the current exchange rates (meaning that it is determined by trade and investment flow)
8. National income statistics are only an imperfect guide to living standards 

GDP, GNP

GDP plus net property income from abroad (NPIFA) equals Gross National Product (GNP)

GDP+NPIFA=GNP

GNP minus depreciation (capital consumption) equals Net National Product (NNP) or National Income

GNP-Depreciation=NNP

AD and SRAS

The equilibrium price level is at P* where aggregate demand (AD) equals short-run aggregate supply (SRAS). If the price level fell below P* then AD>SRAS, if prices go above P* then AD<SRAS.

Aggregate Supply (AS)

Definition= Is the total real output firms are willing to supply at each price level.

Short-run AS (SRAS):

In the short-run (i.e. period of fixed input prices) the SRAS curve will slope upwards. The SRAS curve can sometimes be drawn curving upwards, being considerably steeper as the economy approaches full employment output.

Profit= revenue-cost of production

A change in the price level causes a movement along the SRAS curve but a change in any other determinant will cause the SRAS to shift.

Determinants of SRAS include:

1. Capital (stock)= determined by past capital stock, depreciation and investment.
2. Labour supply= determined by working age population, activity rates, average hours worked and quality of labour
3. Land (Natural resources)
4. Technology
5. Input prices including Import prices (Short-term)
6. Indirect taxes including VAT which raise firm's costs (Short-term)

Any change which increases firm's costs, hence lowering profits, will shift the SRAS curve left. Similarly any change which lowers costs, boosting profits, will shift the SRAS curve right.

Aggregate Demand (AD)

Definition= Is the total level of planned spending in an economy over a given time period.

The Aggregate demand curve:

i.e a curve relating price level to total spending in the economy

The AD curve slopes downwards as:

1. As price level falls international competitiveness rises therefore imports (a withdrawal) fall and exports (an injection) rise therefore AD rises.
2. As price level falls real incomes and real wealth rise therefore consumption rises.

NOTE: A change in the price level will move the economy along the AD curve whereas a change in any other determinant will cause a shift in the AD curve.

Inflation= average/general increase in prices

Real inflation= adjusted inflation

Determinants of AD include:

1. Investment (I)
2. Consumption (C)
3. Government Spending (G)
4. Exports (X)
5. Imports (M)

AD= C + I + G + X - M