Chapter 1 - Aggregate Demand and Aggregate Supply

Question 1

What is aggregate demand (AD) in an economy?

Answer 1

The total expenditure on a countries goods and services at a given price level in a given period of time

Question 2

What is Real GDP?

Answer 2

The value of all final goods and services produced in an economy in a year. Real meaning it is adjusted for inlfation.

Question 3

What is the AD equation?

Answer 3

AD = C + I + G + (X-M)

C = Consumption; (consumer spending)
I = Investment spending; (firm spending on capital goods)
G = Government spending
(X-M) = Net export spending
- X = Export revenue (value of exports)
- M = Value of imports

Question 4

Why does AD slope downwards?

Answer 4

Wealth effect - As the price level rises, the purchasing power of individuals decreases, reducing their marginal propensity to consume and thus reducing C in the AD equation -> contracting AD

Trade effect - As price level increases, competitiveness of domestic exports decreases, reducing their demand and revenue generated from them. Furthermore, imports become more competitive relative to domestic goods, increasing demand and expenditure on them.
X falls, M increases reducing (X-M), -> a contraction of AD

Interest Rate Effect - As price level increases, interest rates will rise in order to bring inflation down -> higher rates increases cost of borrowing and return on savings -> decreasing MPC -> reducing C and I in AD equation -> contraction of AD
High interest rates will strengthen the exchange rate -> making imports cheap -> increasing their consumption -> increasing M -> contraction of AD

Question 5

What factors can shift AD, independent of price?

Answer 5

Determinants of:
-Consumption, affecting (C)
Consumption increases, C increases

-Savings, affecting (C)
Savings increase, C decreases

-Investment, affecting (I)
Investment increases, I increases

-Goverment Spending
Gov will spend to influence economic activity, both SR and LR growth

-Net Exports, affecting (x-m)

Question 6

What happens if the value of the AD equation increases/decreases?

Answer 6

Increases = AD shifts right
Decreases = AD shifts left

Question 7

What are the determinants of consumption? (6)

Answer 7

I.E What factors affect how much consumers consumeee

1) Level of Real Disposable Income
The marginal rate of income tax will influence this. Tax decreases -> RD Income increases -> Marginal Propensity to Consume increases -> (C) increases

2) Interest Rates
Cheaper to borrow = Increased real disposable income, increased (C)
Less payments on borrowed money = House ETC, more RDI, increased MPC

3) Consumer Confidence
Expectations of the future state of economy i.e job losses etc.
If good -> increased MPC -> increased (C)
If bad -> more saving -> decreased (C)

4) Wealth (Asset prices)
In developed countries, strong correlation between wealth and consumption.
Wealth rises I.E Assett Prices Rise -> increased confidence in economy -> increased MPC -> increased (C)

5) Household indebtedness
More debt -> less spendings -> decreased (C)

6) Anticipated inflation
If high inflation forecast -> may consume more now to protect from higher prices in future -> increased spending -> increased (C)
Opposite for anticipated deflation

Question 8

What are the determinants of savings? (5)

Answer 8

I.E What factors affect how much consumers will save or not

1) Level of Real Disposable Income
Individuals can spend or save income -> more income -> more saved

2) Interest Rates
Increased rates -> better return on savings -> increased marginal propensity to save

3) Consumer confidence
Expectations of the future state of economy i.e job losses etc.
If good -> increased MPC -> decreased MP to save
If bad -> more wary -> more likely to save

4) Range and Trustworthiness of financial institutions
In developing countries this is very poor because western branches arent willing to take excessive risk and lend to local business meaning they do not have a need for lots of branches AND education of locals on prupose and benefits of banks is low, reducing deposits and therfore profitability of banks.
Low range and trustworthiness of banks -> low incentive to save

5) Tax incentives like ISAs
Savgins account that offer incentives such as ISAs, wherby savings can be earned tax free up to a threshold, increase MPS

Question 9

What are the determinants of investment? 6

Answer 9

I.E What would make a firm invest more in capital goods

1) Interest rates
Reduces rates -> reduced cost of borrowing for firms -> easier to reach required rate of return for investment projects -> increased investment

2) Level of cooporation tax
If decreases -> increased retained profits -> increased marginal propensity to invest

3) Business confidence
I.E how business expect the level of demand in the future to be
If high -> bullish about state of economy -> happy to take risk and invest -> Increased MPI

4) Capacity utilisation
Closer business are to operating at full capacity the higher their marginal propensity to invest

5) Rate of growth of technology and competition
Business dont want to lose market share to rivals that are growing or investing in better tech -> higher rate of growth of tech and comp -> increased marginal propensity to invest

6) Price of capital
If more expensive -> decreased marginal propensity to invest as MORE RISK

Question 10

Why does the Government spend in the economy (3) + what are the 4 types of Gov spending?

Answer 10

The goverment will spend in an economy in order to:
1) Influence level of economic activity
-In recession Gov can raise spending and increase AD
-In boom with high inflation, Gov can decrease spending and decrease AD

2) Correct market failures and improve AE
Policies to correct under/overproduction / consumption

3) To reduce income inequality and promote equity
Transfer payments and provision of for example social housing

The 4 types of Gov Spending:
‘Current Spending’ - On public sector
‘Capital Spending’ - Infrastructure projects
‘Welfare spending’ - Benefits and pensions
‘Debt Interest Payments’ - Servicing national debt
(last one is leakage from circular flow therefore does not affect AD)

Question 11

What are the determinants of net exports?

Answer 11

I.E What factors affect net exports (X-M)

1) Exchange Rates
SPICED -> Strong Pound Imports Cheap Exports Dear
(X-M) DECREASES as revenue from exports decreases and soending on imports increases
WIDEC -> Weak pound Imports Dear Exports Cheap
(X-M) INCREASES as revenue from exports increases and spending on imports decreases

2) Real Disposable Income EARNED ABROAD
If people abroad get richer -> demand for exports rises -> increased revenue from exports -> increased X -> increased AD

3) Real Disposable Income EARNED AT HOME
If decreases -> marginal propensity to import decreases -> ceteris paribus -> reduces M in (X-M) -> Increases value of (X-M) -> increased AD

4) Government restrictios on free trade
If foregin Govs increases/impose trade barriers on out exports -> decreased revenue from exports -> decreased X in (X-M) -> decreased AD

Question 12

What is aggregate supply?

Answer 12

The total amount of goods and services produced by an economy at a given price level

Question 13

In the classical model, what is the difference between short run and long run aggregate supply?

Answer 13

In the SR, the level of capital is fixed. I.E, You cant build a new factory, but you can hire more workers in the existing factory.
You can increase the utilisation of existing factors of production

Question 14

What does SRAS and shifts of it look like on a diagram?

Answer 14

see flashcard

Question 15

What are the determinants of SRAS? I.E What can shift SRAS?

Answer 15

Think costs of production

1) Raw material prices
If these increase, costs of produciton for all firms in economy will increase -> shifting SRAS left

2) Wages
Most significant cost of prodution for a business -> if these rise -> increased costs of production -> SRAS shifts left

3) Indirect taxes like VAT
These rise -> increased costs of production -> shifts SRAS left

4) Exchange rates
Weak domestic exchange rates -> price of imports dearer -> increased costs of production
VICE VERSA a strong deomestic exchnage rate -> imports cheapers -> decreased costs of production -> SRAS shifts right

Question 16

What is the difference between the Keynsian LRAS and Classical LRAS

Answer 16

Classical -> Is vertical to represent one level of output the economy will always produce at in the long run. This is Yfe: Level of Full Employment, maximum level of output an economy can produce at while using all factors of production SUSTAINABLY.
(it is possible to go over YFE if using unsustainably I.E 24/7 work weeks)

Keynsian -> Agree that there is a level of Yfe, however disgaree that there is SR and LR, stating that we can not utilise all factors of production and still be in the LR

Question 17

Draw the classical and Keynsian models of LRAS

Answer 17

see flashcard

Question 18

How do we know if we are at Yfe?

Answer 18

Looking at whether or not the economy is at the ‘natural rate of unemployment’
In UK this is 4.5%

Question 19

Why is there a horizontal portion of Keynesian LRAS curve?

Answer 19

They believe that when there is a large level of spare capacit, I.E when the economy is in a recession, output can increase without putting excess pressure on existing factors of production given the large amount of unemployed factors in the economy.
Real GDP can increase without any demand pull inflationary pressure.

I.E Firms can employ more workers without having to offer higher wages.

Question 20

What are the determinants of LRAS? I.E what factors can shift LRAS curves (6)

Answer 20

Q²CELL
The quantity and quality of factors of production, what can increase productive capacity of economy

1) Labour Productivity
Improvements in for example education -> boost human capital -> skillws -> labour productivity -> improvement in quality of labour -> LRAS shift right

2) Investment
Spending on new capital, upgrading machinery, builkding new factories ETC
Improves quality and quantity -> shifting LRAS right

3) Infrastructure improvements
Imporvements in transport infrastructure lowers costs of production for firms -> increasing productive efficiency -> increased quality
Imporvements in schools/healthcare improves quiality of workers

4) Competition
Policies that increase competition -> forces firms to be efficient -> increased PE -> increased quality -> shift LRAS right

5) Immigration
Increased quantity of workers -> size of labour foirce -> lras shifts right

6) Institutional structure of economy
Strong structure -> brings together banks and laosn for entrepreuneurs / business -> ensure persistent increases in LRAS

Question 21

When evaluation shifts in AD or AS, meaning changes in Macroeconomic Equlibrium, what 4 variables do we look at the affect on?

Answer 21

Growth / Unemployment / Inflation / Trade Position

Question 22

What is macroeconomic equlibrium?

Answer 22

Where aggregate demand equals aggregate supply

Question 23

Explain the affects shift right in AD using a diagram + EVALUATION POINTS

Answer 23

see flashcard for diagram

Growth = Actual growth increases from Y1 to Y2
-Because with greater demand in economy, firms respond by increaseing output exhausting spare capacity
-Y2 is now closer to full employment level of output
-Increase in output is an increase in real GDP, increase in growth

Unemployment = Decreases
-Labour is a derived demand, as demand for goods and services is high, firms need more workers to produce extra output

Infaltion = increases
-Demabd pull inflation increases from P1 to P2
-Because there is more pressure on existing factors of production, more demand for them, increasing their price and therefore costs for firms. Firms pass on higher costs as higher prices in economy

Trade position = Likely to worsen
Higher inflation -> less competitive exports -> reduced demand for exports -> reduced revenue from exports
ALSO increased growth -> increased incomes -> increased sucking in of imports -> increased spending on imports

Evaluation:
1) Affects depends on initial level of economic activity
If economy is initially operating with a large level of spare capacity (a large negative output gap) -> increase in AD will put less pressure on exisintg factors of production as it is easier to attract labour without the need to offer higher wages -> limiting inflation -> limiting harms to trade position
If LOW LEVEL OF SPARE CAPACITY -> extremelyt difficult for firms to find new workers / increase capital ->level of ouput will not increase as much and there will be enourmous pressure on limited factors of production -> greater rise in inflation -> greater worsening of CA position

2) Affects depends on the size of the multiplier
The greater the size of multiplier, the less that = (Interest rates need to fall, gov spending needs to rise, taxation needs to fall, net exports need to increase etc) in order to have a large effect on ouput and employmeny
Large multiplier -> increase in spending will lead to greater increase in AD -> large final increase in employmenty and growth
HOWEVER greate demand pull inflation

Question 24

Explain a shift right of LRAS using a diagram and evaluation points

Answer 24

see flashcard for diagram

Growth = Potential and actual growth increases from YFE1 to YFE2
Greater demand exisits in economy -> firms respond by increasing output -> increase in GDP -> increase in economic growth

Unemployment = Decreases
Labour derived demand -> increased demand for goods and services -> firms need extra workers to produce output -> reducing unemploymeny

Infaltion = Long run inflation rates decrease from P1 to P2
Less pressure on and compeition for factors of production -> reducing rate of their price increases

Trade position = Likely to improve
Lower inflation -> exports more competitive -> increasing export demand -> increasing revenue brought in by them

EVALUATION:
Depends on initial level of economic activity
If large spare capacity, increase in LRAS would not have any impact on the real economy.
Because -> large spare capacity = unemployment of factors of production is high -> to grow, economy needs to utilise them rather than increase them further
Any LRAS shift will only improve all four key macroeconomic indicators if economy is at or very clsoe to the full employmeny level of ouput

Question 25

What are output gaps in an economy?

Answer 25

Ouput gaps occur when actual output is not equal to Yfe

Negative output gap AKA Deflationary Gap/Recessionary Gap
= Where actual growth is less than potential growth

Positive output gap AKA Inlfationary Gap
= Where actual growth is greater than potential growth

Question 26

Using a diagram, explain a delfationary gap and adjustment in the Classical Model

Answer 26

see flashcard for diagram
1st) Economy is at long stable equilibrium at full employmeny, Yfe, where SRA1 meets AD1

2nd) There is a decrease in AD, from AD1 to AD2, due to for example a fall in next exports

3rd) Firms would rather NOT accept this new equilibrium as it implies laying off trained, skilled workers (reducing employment of factors of production in economy) and would INSTEAD rather reduce wages to lower costs of production and remain at Yfe.

4th) Classical economics argue there are 3 REASONS that wages will not fall in the SR; they are fixed
- High minimum wages, impossible to cut
- High unemployment benefits reduce inscentive to work at lower wages
- Strong TUs would fight wage cut

5th) In this case, firms have to lay off workers, and economy experiences deflationary gap; output is below full employmeny at Y2 and a fall in demand pull inflationary pressure from P1 to P2

6th) However, IN THE LONG RUN wages become variable as deflationary pressure from P1 to P2 and higher unemployment will change workers expectations. Unemployed will revise down wage expectations to find work and employed will do same to remain in work.

7th) Resulting in lower costs of production for firms, increasing production as a result, shifting SRAS right from SRAS1 to SRAS2, where output returns to full employment levels, with lower cost push inflation at P3.

8th) Therefore, classical economics argue that recession are only temporary and economy will SELF-HEAL without need for heavy, debt fueled, Government spending

Question 27

What are the evaluation points for a delfationary gap and andjustment using the classical model? diagram

Answer 27

1) Keynesians argue wages are sticky downwards
(see diagram)
-That no matter what, workers wage expectation will not change, they will not grow to accept lower nominal wages, meaining policy makers will be waiting for an alteration in the economy that will not come.
-Economy stuck in recession, a LR equilibrium at P1 and Y1, suffereing from negative consequences of high unemployment, lower incomes and social costs.
-The Keynesian response is to BOOST AD from AD1 to AD2 with fiscal policy, increases in Gov spending and tax cuts. Increasing economic growth from Y1 to Y2, accepting budget deficits as a side effect (can then run budget surpluses when the boom returns)
-Argue there will not be inflationary conflict given large amount of spare capacity, inflation remains at P1, multiplier affect leading to even larger final increase in real GDP

2) Time
Waiting for a downwards wage adjustment (expectation change) would take years. Classical economics give no indication of how long it would take. Longer it takes, more individuals suffer from unemploymeny, lower incomes, social costs

3) Is debt fueled fiscal policy a better solution? Politician popularity
Keynsian approach is increases debt fueled fiscal policy and spending in economy, causing a budget deficit, and then correct this deficit and service the debt with contractionary fiscal policy during the next boom.
HOWEVER it is possible that politicians do not want to implement contractionary fiscal policy due to impact on their popularity. If this is the case, then there are future consequences of high national debt; tax rises and large cuts to government spending. Future generations bear debt burden.
Classical economist argue that long term price of Keynesian management outweigh short term problems of unemployment and poverty.

Question 28

Explain an inflationary gap and adjustment using the classical model (diagram)

Answer 28

see flashcard for diagram
1st) In the short run, it is possible to deviate from LR equilibrium.

2nd) AD increases from AD1 to AD2 due to a rise in goverment spending for example, there is now more demand in economy

3rd) Ouput increases from Yfe to Y2

4th) Employers are benefiting as they can raise their prices from P1 to P2 but keep wages fixed, thus increasing profits

5th) Workers from the natural rate of employment are being employed, and existing workers are working overtime hours to increase production

6th) Economy experiences inflationary gap; ouput beyong full employment levels with demand pull inflationary pressure from P1 to P2

7th) Workers realise their real pay is not rising however inflation is, they’re overtime is persistent and there is a scarcity of labour with frims competing over workers, this gives them strong bargaining power

8th) They bargain for higher wages, increasing costs of production for firms and as a result shifting SRAS left from SRAS1 to SRAS2. Output falls back to Yfe but with higher cost push inflation from P2 to P3

CONCLUSION) Classical economist say there is no sustainable way to increase GDP beyong Yfe through increasing AD in an economy, the only way would be to use supply side policies that shift LRAS right, increase the full level of employment (reducing natural rate of unemloyment)