What does aggregate mean?
What is aggregate demand?
The total level of expenditure on all domestic goods and services
What is the formula for AD?
C + I + G + X - M
What does an aggregate demand graph look like?
Price level is along the y axis and real output is along the x axis. The aggregate demand curve slopes downwards.
Why does the aggregate demand curve slope downwards?
The purchasing power of economic agents rises as price level falls.
What will lead to aggregate demand shifting outwards?
An increase in C, I, G and X. A decrease in M.
Which leads to a shift in the AD curve - exogenous shocks or changes in price level?
What is an exogenous shock?
A change in a variable which affects at least one of the AD components but which itself is outside the AD model.
What causes consumption to increase?
An increase in population, interest rates falling, increase in consumer confidence, rise in real incomes, rising wealth, increase in employment and a decrease in income tax.
When would consumer confidence increase for instance?
When the economy is coming out of a recession or when the price of assets increases.
Why would interest rates falling cause consumption to increase?
People won't want to save their money if they aren't going to get anything in return and they are also more likely to take loans if there are low interest rates.
What would cause investment to increase?
A rise in profits, a decrease in corporation tax, investor/business confidence increasing, government policies promoting investment such as subsidies, the level of risk decreasing and falling interest rates.
What would cause government spending to increase?
A change in legislation leading to a rise in government spending.
Why would spending on transfer items not be included in aggregate demand?
This doesn't show the demand for a good or service and it would also be counted as consumption.
What would cause net imports to increase?
A rise in the UK price competitiveness, a rise in the UK's non-price competitiveness and the exchange rate.
What is the wealth effect?
This refers to the impact of rising asset prices on both the willingness and ability of consumers to increase their spending on the high street. This is because their confidence in the state of the economy changes.
What does investment include?
Only physical tangible investment.
What is the result of a weaker pound?
We import less and export more.
What does MPW stand for?
Marginal propensity to withdraw
Why do we include export demand which is demand from foreign consumers?
We are not interested in who is demanding as this is the total expenditure on domestic goods and services.
Why do we subtract import expenditure?
It's a withdrawal - essentially there is lost demand as we could have had it in the UK economy.
Why won't a cut in taxes mean that government expenditure will decrease?
The government spends what it wants even if it goes into debt.
What is the multiplier effect?
Where an increase in an injection (I, G or X) causes a proportionally greater increase in GDP.
What is MPC?
The proportion of extra income spent on consumer goods is called the marginal propensity to consume.
How is the multiplier (K) calculated?
K = 1/1-MPC
What is MPC + MPW equal to?
What is the increase in AD equal to?
Multiplier x injection
What is another way to calculate the multiplier?
K = 1/MPW
What are some evaluation points about the multiplier?
The MPC may not be accurate, the value of it may not be constant overtime as cycles go by, the multiplier process takes time, the multiplier is very hard to measure and isolate from other influences, the impact on GDP depends on the relative position with the AS curve and future changes in tax/spending may cancel out the effects.
What are interest rates?
The price of money.
What do savers prefer in terms of interest rates?
High interest rates.
What do interest rates represent for borrowers?
The cost of borrowing.
What do interest rates represent for savers or lenders?
The rewards for saving.
Why would changing interest rates not necessarily impact individuals and their mortgage repayments?
Some people have a fixed rate mortgage and their repayments are not affected by the Bank of England base rate and commercial banks such as Natwest may not follow the Bank of England interest rate.
What effect does demand increasing for the pound have?
It creates a stronger sterling exchange rate.
Why won't an increase in UK interest rates necessarily lead to a stronger sterling exchange rate?
There are many other factors that affect UK interest rates and they could lead to the pound becoming weaker and also if other countries increase their interest rates by a higher amount then the relative interest rate for the UK has actually fallen.
What is aggregate supply?
The total level of real output of all domestic goods and services.
What does the classical model say will happen in the long run?
Wages and prices are flexible ensuring that the economy always operates at the full capacity level.
What does the Keynesian model say about wages in the long run?
Wages and prices are 'sticky downwards' meaning that wages can't fall and are hard to fall due to things such as strikes. Unemployment could persist even in the long run.
What do the classical model and the Keynesian model both agree about?
That unemployment may persist in the short run. Money wage rates and all factor input prices are fixed.
What will firms do if they want to produce more output in the short run?
They are unlikely to hire extra workers as this is costly so they will ask their workers to work overtime, this requires extra overtime pay which will result in firms choosing to increase their prices.
How is the full employment level of output denoted?
According to the classical model, in the long run will we always operate at the full employment level and why is this the case?
Yes as wages will self-adjust.
In the long run, what will an effective shortage of labour cause?
An upward pressure on wages.
How might firms respond to a lack of demand in the short run?
By reducing wages/accepting lower productivity from workers or by firing workers.
What will surpluses in the labour market cause in the long run and what effect does it have on the SRAS curve?
A downwards pressure on wages. This causes the SRAS curve to shift downwards.
According to Keynesian economics, what will happen to the economy when it is at full capacity at high levels of output and is this also the case for classical economics?
It will be represented by a perfectly inelastic line which is what classical economists believe as well.
What is possible in Keynesian economics?
For the economy to operate below the full capacity level.
What would cause increases in the full employment level?
Immigration, an increase in the retirement age and advances in technology.
What would cause the AS curve to shift to the right?
If YFE increases and this could be caused by having more factors of production or having a more highly productive set of factors of production (essentially things that shift the PPF outwards).
What is productivity?
The value of output per unit of factor input.
What does an increase in the costs of production do?
YFE does not change however AS would shift up as price levels become higher at every level of output.
What would a reduction of income tax lead to?
Inflow of immigration workers, an increase in consumption and the economically inactive may start to become a part of the working population.
Why is there a positive relationship for the AS curve?
As price level increases, firms have more of an incentive to expand output as they will become more profitable.
Why is there an inverse relationship for AD?
When the price of goods in the economy fall, there is more demand for those goods.
Why is there a full employment level?
We only have a certain amount of of the four factors of production which limits us.
What does the full employment level show?
The maximum that can be produced using all the factors of production that are available.
What is economic growth and is an increase in real output good for ths objective?
This is defined as the rise in the level of real output produced in an economy. If real output increases then this is good for economic growth.
How does an increase or a decrease in price level affect the target of low and stable inflation?
If price level increases then this is generally bad for the price stability objective, however when price level moves downwards this is usually better for the price stability objective. On the other hand too big a movement downwards could cause deflation which is bad.
Is an increase in real output good for employment levels?
If output increases, then more workers are needed to produce this output as labour is a derived demand so whenever output increases, this is good for the full employment objective.
Is real output increasing good for the balance of payments?
An increase in real output requires more workers to produce this output so employment rises. This means that average income is higher and so more will be spent on imports. The economy will therefore see a larger BoP deficit. The objective is not met when real output increases as a larger deficit is made.
What is the largest component of aggregate demand and how much does it account for?
Consumption and it accounts for 60-70% of aggregate demand.
What do C, I, G, X and M stand for in AD?
C = consumption, I = investment, G = government expenditure, X = export earnings and M = import expenditure
How much does investment comprise of AD?
What does a shift in AD show?
How real output has changed independently of the price level.
Why would interest rates falling cause investment to increase?
Firms are more likely to borrow money as the cost of borrowing is lower and it makes it more worthwhile for firms to take out a loan in order to buy capital goods.
What would cause an increase in UK price competitiveness?
A fall in the sterling exchange rate and a fall in interest rates.
What would cause an increase in the UK's non-price competitiveness?
Better quality goods, innovation, technology and branding.
What is the general price level?
A weighted basket of all prices in the UK economy.
What is GDP?
The total output of goods and services produced by all firms in the UK economy.
How will increasing consumer confidence lead to consumption increasing?
If consumers feel optimistic about the general state of the economy and about their own job prospects, they will tend to spend more of their income and save less of it.
Why do rising incomes cause consumption to increase?
This will give consumers greater purchasing power so the demand for all goods and services should rise as a result.
Why does a fall in income tax lead to an increase in consumption?
This will raise disposable income leaving consumers with more money to spend on the high street.
What is disposable income?
Income after taxes and immediate expenses have been deducted.
How does falling unemployment lead to an increase in consumption?
This will ensure that more people in the UK economy have a regular income and can therefore afford to buy more goods and services.
Why does increased business confidence lead to a rise in investment?
For most firms, investment in new capital can be very expensive and a very risky commitment, therefore firms will need to feel optimistic about the general state of the economy before undertaking such high levels of spending.
What will an expected recovery or boom lead to in terms of investment?
It will raise expectations of future demand hence making firms more willing to buy new capital goods.
How does increased profitability lead to an increase in investment?
Firms have greater funds with which to purchase new capital, expand existing factories and so on.
How does the level of risk impact investment?
The smaller the risk, the higher the level of investment in the economy.
What is meant by a rise in the external price competitiveness of UK goods and services?
This means British-made goods become relatively cheaper than foreign goods.
Why would a fall in the sterling exchange rate cause a rise in UK price competitiveness?
It makes exports cheaper to our foreign customers and imports more expensive to UK consumers.
Why would a fall in interest rates cause a rise in UK price competitiveness?
It will cause a fall in the exchange rate by prompting an outflow of hot money.
How would a rise in UK price competitiveness cause net exports to increase?
More foreigners will buy UK goods and more British consumers will switch from imports to the cheaper British substitutes.
What does a rise in the non-price competitiveness of UK goods and services mean?
This means British-made goods become more desirable than foreign goods, irrespective of their price, and therefore have a low PED.
Why would an increase in the quality of British goods cause UK non-price competitiveness to increase?
It may mean greater durability of British goods or a higher quality of after-sales service.
Why would incorporating more advanced technology lead to an increase in UK non-price competitiveness?
It may mean UK goods are seen to be more innovative and therefore more desirable than foreign products.
Why would high levels of branding lead to an increase in UK price non-competitiveness?
It would enhance people's perceptions of British goods and therefore raise customer loyalty.
Why would an increase in UK non-price competitiveness lead to an increase in net exports?
More foreigners will buy UK goods and more British consumers will switch from imports to the more desirable British substitutes.
How does economic boom in the rest of the world lead to a rise in net exports?
This will promote export demand as our trading partners will have rising incomes and will spend some of this on UK goods.
How does inflation impact the AD curve?
It causes movements along the AD curve.
How can government spending have other effects on AD?
Wages are paid to building firms, shops then sell the goods and services and their staff are paid wages. This leads to an increase in consumption and investment.
What is the opposite of the multiplier effect and give an example of when it would occur?
The negative multiplier effect and it would occur if the government were to cut its spending.
Why is the multiplier very hard to measure and isolate from other influences?
We don't know how much is due to the multiplier itself or the economy.
What do borrowers prefer in terms of interest rates?
Low interest rates.
How would an increase in interest rates affect people who have a mortgage?
Their monthly mortgage repayments would increase so there would be a fall in disposable income meaning that consumption would fall and AD would shift inwards.
What effect do interest rates have on the purchase of luxury goods/consumer durables?
The purchase of luxury goods/consumer durables will be postponed until rates fall as an increase in interest rates will raise the cost of taking out new loans and credit. This mainly affects the demand for consumer durables
What are consumer durables?
Goods and services which will last a long time.
What effect does increasing interest rates have on savers?
It will increase the reward for saving thus raising the MPS and the savings ratio.
What does MPS stand for?
Marginal propensity to save.
What does a fall in the marginal propensity to consume lead to?
The marginal propensity to save rises.
How does an increase in interest rates effect firms who are planning a new investment project?
It will increase the cost of borrowing and the return on saving by firms which leads to a postponement or cancellation of all investment projects where the marginal efficiency of capital is less than the interest rate as firms will avoid taking out new loans and put retained profits into savings. This lowers the investment component of AD.
Why does demand for the pound increase if interest rates increase?
It leads to an inflow of 'hot money'.
What is meant by an inflow of 'hot money'?
People looking to store money from abroad into UK accounts.
What effect does a strong pound have on imports and exports?
It means imports are cheaper and therefore you import more and export less as it is more expensive.
What is the effect of wage rates increasing overtime?
Firms will respond by increasing prices at each and every level of output. This leads to an upwards shift of the SRAS curve.
What is the effect of the costs of production decreasing?
Firms will respond by decreasing prices which causes a downwards shift in the SRAS curve.
Does a positive exogenous shock have the same impact in both the classical model and the Keynesian model?
What is the effect of an exogenous shock on AD (which causes it to shift outwards) in the short run when wages are fixed and the economy is operating at the full capacity level?
Firms are likely to respond by asking workers to work overtime but we are already operating at the full capacity level so it is not possible to recruit more workers. The result is inflation .
Until what point will wages continue to increase?
Until the labour market has re-established equilibrium i.e. until we return to the full employment level of output.
Why might wages find it difficult to fall?
Due to national minimum wages, trade union disputes and the reluctance to do so by firms due to negative impacts on worker productivity.
Why does unemployment persist in the long run when wages are sticky downwards and what is the effect of this?
The labour market is unable to correct itself via the wage mechanism. The effect of this is that firms can fire workers with no downward effect on wages and thus it is unlikely that prices need to fall further in the economy.
What causes the SRAS curve to shift?
A change in the costs of production.
When does macroeconomic equilibrium occur?
The point at which AS is equal to AD.
What will cause the macroeconomic equilibrium to change?
When there is a shift in one/both curves.
How are time lags an evaluation point?
Consider the short run and the long run as only one curve may be effected in the short run but perhaps both could be affected in the long run.
What are some evaluation points you could make about AS/AD shifts and their effects?
The magnitude of impact on AD will vary depending on the region of the UK, it depends upon the level of spare capacity in the economy, if prices are given in another currency then the exchange rate must be considered, the magnitude of the changes in prices, time lags, significance and relaxing the ceteris paribus assumption.
What is the effect of a larger spare capacity?
There will be a greater fall in output (If AD shifted inwards) and a smaller decrease in price level.
How is the magnitude of the changes in price an evaluation point?
The effect on price level and real output may not be very significant.
On what part of the AS curve is the UK economy operating?
The elastic part.
How can significance be used as an evaluation point?
By referring to the level of spare capacity in the economy.
What is the ceteris parabus assumption?
Other things being equal.
How can the relaxing of the ceteris parabus assumption be used as an evaluation point?
The reality is that other things are rarely equal so there may be changes in other variables that partially or totally offset the changes described in the question.
When there is a recession, what is the impact on the level of spare capacity in the economy?
There is a larger capacity.
How should you structure an AS-AD question?
Draw an AS-AD diagram, explain the AS/AD shifts, explain the impact on price level and real output (if the impact is on the economy then look at the macroeconomic objectives), apply by using the data and then state two evaluation points.
What does the multiplier effect cause?
A cycle of re-spending where one person's spending becomes another person's income.
What will the final effect of the multiplier process depend on?
How much is saved and consumed by each group at each round.
What is the effect of people spending more of their additional income?
The multiplier effect will be higher.
What is happening to any income that is not being consumed?
It is leaving the circular flow of income in the form of savings, taxes or imports.
If an individual's income rises by £10 and they spend £8 then what is their MPC?
What is the concept of the multiplier in terms of the full capacity of an economy?
A government need only inject a fraction of the value of the output gap in order to bring the economy back to full capacity.
What is the transmission mechanism of interest rates?
The routes through which interest rates influence the components of AD.
How might higher interest rates lead to a fall in house prices?
Mortgages become less affordable and this can have a negative wealth effect where lower house prices may mean households are less inclined to spend and less able to take out loans based on the equity in their homes.
What is equity?
The value of a mortgaged property after deduction of charges against it.
What is the effect of hot money inflows on exports?
It raises the price of exports but the volume of exports falls.
What is the effect of UK interest rates rising relative to that of other countries?
The rate of savings return on UK bank accounts will increase leading to an inflow of hot money.
What is the Economic cycle?
How the performance of an economy tends to vary over time.
Is it inevitable that an economy will go into recession just after a boom period?
No as economies can grow steadily for many years without going into recession.
What happens during boom periods in terms of AD and capacity?
We come close to using all of our capacity (if not producing above our maximum output level). A positive output gap will exist. AD rises.
How do firms respond to an increase in AD?
They increase their output.
What happens during times of recession in terms of AD and the output of the economy?
The economy deviates away from its potential output. AD decreases.
How do firms respond to a decrease in AD?
Firms employ fewer people and incomes fall, so the level of expenditure falls too.
Is it possible for actual output to be greater than potential output?
When does a negative output gap exist?
When actual output is below potential.
What is the inverse relationship of AD caused by?
Imports, real income effect and interest rate effects.
How do imports cause the inverse relationship of AD?
If the price of domestic goods rises, the price of imported goods will become relatively cheaper so domestic output will fall.
How does the real income effect cause the inverse relationship of AD?
If prices rise faster than people's incomes, this will mean that their purchasing power will fall so expenditure will fall too.
How do interest rates cause the inverse relationship of AD?
A rise in the general level of prices constitutes inflation. Interest rates are often used as a weapon with which to combat inflation and rising interest rates will reduce expenditure.
What is consumption?
Consumer spending on goods and services. It includes demand for durables and non-durable goods.
How can you calculate the MPC?
Change in consumption/change in income.
What is autonomous consumption?
Consumption that is present when no income is earned due to borrowing or using savings.
What is the formula for overall consumption?
Autonomous consumption + the marginal propensity to consume.
What are some examples of physical wealth?
Houses and cars.
What are some examples of monetary wealth?
Cash, money in bank accounts and pension rights.
How does the availability of credit impact consumption?
Banks may cut back on the amount of money they are willing to lend out.
How do expectations of price increases and large increases in income lead to an increase in consumption?
Expectations of price increases tend to make households bring forward their purchases and expectations of large increases in income tend to encourage households to spend now by borrowing more.
What are some of the factors that affect consumer confidence?
Expectations of future living standards and income levels, unemployment trends, perceptions of job security and expectations of changes in taxation.
What is the problem with consumer confidence?
It is notoriously difficult to measure and it tends to be quite volatile from month to month.
What is investment?
The addition to the capital stock of the economy by firms - factories, machines, offices and stocks of materials, used to produce other goods and services.
What is depreciation?
The value of capital stock depreciates as it wears out and is used up.
What is net investment equal to?
Gross investment - value of depreciation.
How will a rise in national income cause investment to increase?
There is an increase in demand for goods and services so some firms may need to expand their capacity.
What is the Accelerator Theory of Investment?
The theory that a rise in national income will trigger a rise in investment.
What is the Marginal Efficiency of Capital Theory?
The inverse relationship between the rate of interest and the amount of investment undertaken.
What is retained profit?
Profit that is not distributed to shareholders.
What is corporation tax?
A tax levied on firms' profits.
How can relative factor prices lead to an increase in investment?
If the price of labour is high (relative to capital) then the level of investment should increase.
What is the assumption associated with relative factor prices?
Labour and capital can be substituted easily.
What is government spending viewed as being determined by?
The political convictions of a party therefore political preferences rather than economic variables are said to explain government expenditure.
How can tax revenues impact government spending?
In the short run, it may reduce the extent of economic growth however in the long run increased tax revenues may tempt the government to increase its expenditure.
How can the size of the output gap affect the level of government spending?
A government may be unwilling to increase its expenditure if the economy is at full capacity for fear that this will create inflationary pressure.
How do foreign incomes affect net exports?
As foreign incomes rise, the demand for UK exports should increase.
How does protectionsim impact net exports?
If other countries have high tariffs or quotas, this will reduce UK exports.
What does the SRAS show?
The sum of all individual firms' supply curves and it shows the level of output that firms are prepared to produce at each price level.
What do monetarists believe?
Markets always clear so demand always equals supply, therefore zero unemployment should eventually occur.
What is the effect of inflaiton in terms of workers?
Workers will react to this by lobbying for higher wages.
Why do Keynesians believe that the economy does not always operate at the full capacity?
Due to the existence of market failure.
What is the effect of the existence of market failures?
Wage and price signals will not be sufficient to bring the economy back to full capacity in the short run.
When the AS curve is horizontal, what does this imply?
There is spare capacity within the economy.
Why does an increase in AD create no inflation whatsoever when the AS curve is horizontal?
There are so many spare resources in the economy that there is no upward pressure on wages or raw material prices.
What is demand management?
When the government manipulates the level of aggregate demand thereby ensuring that the economy operates at full capacity.
How is demand management achieved?
Through the use of demand-side policies.