3.2: AD/AS Model

Question 1

Aggregate Demand (AD)

Answer 1

Total demand for the output (everything a nation produces) of a nation at a range of price levels in a particular period of time from all consumers (Domestic and Foreign)

Question 2

Is Aggregate Demand upward or downwards sloping

Answer 2

Downwards

Question 3

Reasons the AD Curve slopes down

Answer 3

The Wealth Effect, The Interest Rate Effect, The Net Export Effect

Question 4

The Wealth Effect

Answer 4

Higher price levels reduce the purchasing power or the real value of the nations household wealth and savings

• When prices go up, people’s money and savings can’t buy as much, so they feel poorer.
  Because of that, they spend less, and demand for goods and services goes down.
• When prices go down, people feel richer because their money can buy more. So they spend
  more, and demand goes up.

Question 5

The Interest Rate Effect

Answer 5

In response to higher price levels, banks will increase the interest rates on loans to households and firms who wish to consume or invest

• When interest rates are high, people and businesses borrow less and spend less, so demand
  for goods and services goes down. (AD Decreases)
• When prices go down, people need less money, so interest rates fall. Borrowing becomes
  cheaper, so people and businesses spend more, and demand goes up. (AD Increases)

Question 6

The Net Export Effect

Answer 6

As price levels in a county falls/rises goods and services in the country become more/less attractive to foreign consumers

• When prices go down in your country, consumers will view foreign goods as more expensive so
  therefore they will buy less foreign goods (imports) (AD Increases)
• When prices go up in your country, the opposite happens consumers will view foreign goods as
  cheaper, therefore people will buy more foreign goods leading to demand in the country
  dropping (AD Decreases)

Question 7

What Causes a Movement Along the AD Curve

Answer 7

Wealth Effect, Interest Rate Effect, Net Exports Effect

Question 8

Shifts in the AD Curve

Answer 8

Household consumption (C), Capital Investment (I), Government Spendings (G), Net Exports (Xn)

Question 9

Household consumption (C)

Answer 9

Spending by consumers

Question 10

Capital Investment (I)

Answer 10

Spending by businesses on equipment, buildings, etc

Question 11

Government Spendings (G)

Answer 11

Spending by government on goods and services

Question 12

Net Exports (Xn)

Answer 12

Exports - Imports

Question 13

Which way does the AD Curve shift if there is an INCREASE in price level

Answer 13

Shifts right/Upwards to AD2

Question 14

Which way does the AD Curve shift if there is an DECREASE in price level

Answer 14

Shifts Left/Downwards to AD3

Question 15

The Determinants of Household Consumption (C)

Answer 15

• Disposable Income
• Wealth
• Expectations
• Real Interest Rates
• Household Debts
• Taxation

Question 16

Determinant of Household Consumption: Disposable Income

Answer 16

Refers to the after tax incomes of households. As disposable income rises, C will increase. If disposable income falls, C will fall

Question 17

Determinant of Household Consumption: Wealth

Answer 17

When the value of existing wealth (real assets and financial assets) increases, households tend to spend more on goods and services. When wealth decrease, consumption decreases

Question 18

Determinant of Household Consumption: Excpectations

Answer 18

If households expect prices or their incomes to rise in the future then C increases, shifting AD out. If they expect lower prices in the future then C will decrease, as they will most likely save their money for cheaper prices

Question 19

Determinant of Household Consumption: Real Interest Rates

Answer 19

Lower real interest rates leads to more C, as saving becomes less appealing and borrowing to buy durable goods (TVs, Cars, Phones, etc.) can be done more cheaply

Question 20

Determinant of Household Consumption: Household Debts

Answer 20

When consumers increase their debt levels, they can consume more in the short-run, but if household debt is too high, C will eventually decrease

Question 21

Determinant of Household Consumption: Taxation

Answer 21

Higher taxes decrease disposable income and cause C to fall. A decrease in taxes shifts both C outwards. Taxes are set by the government as part of a fiscal policy

Question 22

The Determinants of Investment (I)

Answer 22

• Real Interest Rates
• Business Confidence
• Technology
• Business Taxes
• The Degree of Excess Capacity
• Expectations

Question 23

Determinant of Investment: Real Interest Rates

Answer 23

The cost of borrowing money. Firms will borrow more money to invest in new capital when the interest rate is low, and invest less when interest rates are high

Question 24

Determinant of Investment: Business Confidence

Answer 24

When firms are confident about the future demand for their products they are more likely to invest, if confidence is low they won’t make new investments

Question 25

Determinant of Investment: Technology

Answer 25

Newer technologies lead to new business investments. They allow companies and firms to make production of goods and services to become more efficient allowing them to meet the demand the consumers are asking for

Question 26

Determinant of Investment: Business Taxes

Answer 26

When first are able to keep more of their revenue (tax is low) they will invest more. Higher taxes on businesses discourage new investments

Question 27

Determinant of Investment: The Degree of Excess Capacity

Answer 27

If firms have excess capacity (they are producing goods/services below the level they are capable of) they will me less likely to inches since their output can still be increased without the need to have new capital or resources

Question 28

Determinant of Investment: Expectations

Answer 28

If firms expect their prices of their goods or services to increase in the future they are more likely to invest earlier. If lower prices are expected they will have less of a want to invest

Question 29

The Determinants of Government Spendings (G)

Answer 29

- Government Budgets - Contractionary Fiscal Policy - Expansionary Fiscal Policy - Budget Deficit - Budget Surplus

Question 30

Fiscal Policy

Answer 30

Fiscal policy is when the government changes how much it spends or taxes to control how much total demand (AD) is in the economy.

Question 31

Determinant of Government Spendings: Government Budgets

Answer 31

Changes in the levels of government spendings are reflected in the government's budget, towards which taxes revenues go in order to finance government expenditures.

Question 32

Determinant of Government Spendings: Contractionary Fiscal Policy

Answer 32

If the government reduces its spendings and/or increases the level of taxations, aggregate demand will decrease and shift left

Question 33

Determinant of Government Spendings: Expansionary Fiscal Policy

Answer 33

If the government increases its spendings and/or decreases the level of taxation, aggregate demand will increase and shift right

Question 34

Determinant of Government Spendings: Budget Deficit

Answer 34

When the government runs a deficit (expenditures exceed tax revenues), then the government spending will contribute to the AD that year, leading to a increase and shift to the right

Question 35

Determinant of Government Spendings: Budget Surplus

Answer 35

If a government runs a surplus (spendings are less then collected tax) then fiscal policy will subtract from aggregate demand, shifting it to the left

Question 36

The Determinants of Net Exports (Xn)

Answer 36

- Foreign and Domestic Incomes - The Exchange Rate - Protectionism - Tastes and Preferences

Question 37

Determinant of Net Exports: Foreign and Domestic Incomes

Answer 37

If the incomes of households in other countries increase, then demand for a country's exports should increase and net exports should rise. If the domestic incomes increase, demand for imports will increase and exports will fall

Question 38

Determinant of Net Exports: The Exchange Rate

Answer 38

This is the value of a nation's currency compared to other currencies. When exchange rate increases, countries goods become more expensive leading to less foreign consumers buying it, but imports become cheaper causing net exports to fall

Question 39

Determinant of Net Exports: Protectionism

Answer 39

Policies put in place by the government to reduce trade between nations. By doing this it will increase demand for imports in a country, this may cause net exports to fall. It could also increase demand for exports, causing net exports to increase

Question 40

Determinant of Net Exports: Tastes and Preferences

Answer 40

When a country's goods become more appealing to foreign consumers, demand for them will rise and net exports will increase

Question 41

Aggregate Supply Curve

Answer 41

The Aggregate Supply curve is upwards sloping, there are 2 different curves short run aggregate supply (SRAS) and long run aggregate supply (LRAS)

Question 42

SRAS

Answer 42

Illustrates the relationship between price level of a nation's output and the level of the output produced in the fixed wage and price period. This is the time period in which there has been a change in the aggregate demand (AD) over which the workers wages and prices are relatively inflexible (not changing)

Question 43

LRAS

Answer 43

Illustrates the relationship between price level and level of output in the flexible wage and price period. This is the period of time following a change in the aggregate demand (AD) where all prices are and wages in the economy can adjust to the level of demand.

Question 44

Competing Views of Aggregate Supply

Answer 44

- The Classical View - The Keynesian View

Question 45

The Classical View

Answer 45

Believes that the economy can fix itself without government help because wages and price are flexible. - The New Classical View is correct in the long run because wages and prices adjust over time, no matter how much spending (aggregate demand) changes

Question 46

The Keynesian View

Answer 46

Believes that the economy is unable to fix itself therefore the government is required to intervene to fix it - Keynes View is correct in the short run because wages and price usually adjust quickly to change in demand

Question 47

SRAS Curve (Shape)

Answer 47

- The curve slopes upward because at higher prices firms will respond by producing greater quantity of goods and services - As prices decrease, firms will produce a lower quantity, as reflected in the curve. - At lower levels of output there is a greater amount of unemployment, this means firms are able to attract newer workers at lower prices, this causes the prices to rise gradually as output increases - At higher levels of output, the economy is fully employed, making it harder for firms to increase output as it is more costly as they have to increase wages and other costs. An increase will lead to greater levels of inflation as an economy approaches and passes full employment

Question 48

LRAS Curve (Shape)

Answer 48

- LRAS is vertical at the full employment level of output (Yfe), implying that whatever level of AD, the economy will always produce at full employment - When AD is very low, wages and price falls so that firms can keep employing the same number of workers and produce the same output. Output does not change when AD decreases - When AD is high, firms will see wages rising so they don't have to hire more workers, and will instead put higher costs onto buyers. Output will not increase when AD increase

Question 49

The Determinants of Aggregate Supply

Answer 49

- Wage Rates - Resource Costs - Energy and Transportation Costs - Government Regulation - Business Taxes - Exchange Rates

Question 50

Wage Rates

Answer 50

The cost of labor. Higher wages cause SRAS to decrease and lower wage rates cause SRAS to increase

Question 51

Resource Costs

Answer 51

Rents for land, interest, capital; as these rise and fall so does AS

Question 52

Energy and Transportation Costs

Answer 52

Higher oil or energy prices will cause SRAS to decrease. If costs decrease SRAS increases

Question 53

Government Regulation

Answer 53

Regulations can be put in place which impose costs on firms, this can cause SRAS to decrease

Question 54

Business Taxes

Answer 54

Taxes are a monetary cost imposed on firms by the government, higher taxes will cause SRAS to decrease

Question 55

Exchange Rates

Answer 55

If producers use a lot of imported raw materials, a weaker country will cause these imports to become more expensive, causing SRAS to decrease. A stronger currency will do the opposite and make SRAS increase as these goods are now cheaper to purchase

Question 56

Supply Shocks

Answer 56

A supply shock is an unexpected event that suddenly changes the supply of a product or commodity, resulting in a sudden change in its price. This can be either positive, leading to a sudden increase in supply, or negative, causing a sudden decrease.

Question 57

Stagflation

Answer 57

An increase in the average price level combined with a decrease in output, caused by a negative supply shock. “Stagnant growth” and “inflation” together make “stagflation”