Unit 4 - Chapter 17 - Aggregate demand and aggregate supply

Question 1

Define AD

Answer 1

Aggregate demand (AD) describes the total spending of consumers (households), firms and the government plus foreigners’ spending on the country’s exports minus spending by the country’s consumers, firms and government on imports.

Question 2

Is imports counted in C, I, G?

Answer 2

Yes
这也是为什么我们还要特意把imports从AD减去。

例如C，其实是加上了consumer买国内和国外生产的产品。但是毕竟GDP只算买国内生产的，所以得把imports那部分特意减去。

Question 3

Define C

Answer 3

Consumption (C): This is also known as consumer expenditure. It consists of spending by households on goods and services.
Example: spending on food, clothing, travel and entertainment.

Question 4

Define I

Answer 4

Investment (I): This is spending by private sector firms on capital goods.
私人投资
Example: factories, offices, machinery and delivery vehicles.

Question 5

Define G

Answer 5

Government spending (G): This covers government spending on goods and services.
Example: expenditure on providing merit goods, such as education and healthcare, and public goods, such as defence

Question 6

Is transfer payment in G?

Answer 6

No.

Question 7

Are interest payments on gov. bonds in G?

Answer 7

No

Question 8

Define NX

Answer 8

Net exports (X–M): This is the difference between the value of exports of goods and services and the value of imports of goods and services.

Question 9

NX计算的是 数量还是金额？

Answer 9

金额

Question 10

Why is AD downward sloping?

Answer 10

The wealth effect (C): A rise in the price level will reduce the amount of goods and services that people’s wealth can buy. The purchasing power of savings held in the form of bank accounts and other financial assets will fall.
The international effect (X-M) A rise in the price level will reduce demand for net exports as exports will become less price competitive while imports will become more price competitive.
The interest rate effect (C/I): A rise in the price level will increase demand for money to pay the higher prices. This, in turn, will increase the interest rate. A higher interest rate usually results in a reduction in consumption and investment

Question 11

Identify FIVE determinants of consumption

Answer 11

1. Expectation
2. Level of disposable income
3. Wealth
4. Interest rate
5. Credit availability
6. Population size
7. Income distribution

Question 12

How does expectations influence consumption?

Answer 12

When people become more optimistic that their future jobs are secure and that their incomes will rise, they are likely to increase their current spending (even if current income has not yet increased).

Question 13

How does disposable income influence consumption?

Answer 13

Higher disposable income, resulted from a cut in income tax, for instance, encourages spending, as households can afford more goods and services.

Question 14

How does wealth influence consumption?

Answer 14

Households are likely to spend more if they become wealthier. They can sell some of their assets to purchase, for example, a car. They can also use their wealth as security for repayment of a loan

Question 15

How does credit availability influence consumption?

Answer 15

A greater availability of credits makes borrowing for spending cheaper and more accessible, boosting consumption.

Question 16

How does population influence consumption?

Answer 16

A larger population means higher aggregate demand.

Question 17

How does income distribution influence consumption?

Answer 17

A more equal income distribution: when rich people lose income they are unlikely to cut back on their spending significantly, while people on low incomes who gain more income will spend most of the extra
On the other hand, if income becomes more unevenly distributed, consumption may fall as the rich spend a smaller proportion of their income.

Question 18

Identify FIVE determinants of investment

Answer 18

1. Consumer demand
2. Interest rate
3. Advances in technology
4. Business confidence (Expectation)
5. Gov. policies, e.g. size of corporate tax rate and the size of subsidies

Question 19

How does consumer demand influence investment?

Answer 19

Change in consumer demand is a very important influence on investment. If consumer demand rises, firms are likely to want to buy more capital equipment to expand their capacity.

Question 20

How does advances in technology influence investment?

Answer 20

Advances in technology will introduce new products and raise productivity of capital goods and so will probably stimulate more investment.
Also, there may be a fall in the price of capital equipment and/or cost of installation of capital goods, raising investment.

Question 21

How does uncertainty influence investment?

Answer 21

When firms feel uncertain or pessimistic about economic conditions, they may believe that the demand for their products will fall, they will be reluctant to invest. If there is, for instance, a report from a well-respected source that there will be a recession, firms may cut their spending on capital goods by a significant amount.

Question 22

How does EXPECTATION influence investment?

Answer 22

When firms feel optimistic that economic conditions are improving and demand for their products will rise, they will be encouraged to raise their investment. If there is, for instance, a report from a well-respected source that there will be strong growth, firms may increase their spending on capital goods by a significant amount.

Question 23

How does policies influence investment?

Answer 23

Governments can also seek to increase private sector investment by cutting corporate tax (the tax on company profits) and by providing subsidies.

Or a cut in income tax would increase disposable income, which is likely to encourage people to spend more which can encourage firms to expand their output

Question 24

Interest rate 定义

Answer 24

一般分析：
Interest rate is the cost of borrowings and the returns on savings.

在money market的情境下，interest rate的定义：
interset rate is the opportunity cost of holding moeny

Question 25

How does interset rate influence consumption?

Answer 25

argumentment 1 A rise in the money supply leads to lower interest rate. A lower interest rate means the returns of savings and the cost of borrowing decrease. Households are more willing to spend rather than save as the OC of consumption drops.

argumentment 2 Also, they are more willing to borrow to buy expensive items such as housing, luxury holidays and cars.

Question 26

How does interset rate influence investment?

Answer 26

(1) The cost of investment will fall. Firms that borrow to buy capital goods will find it cheaper.

(2) Firms can save retained profits and earn interests. Alternatively, firms can use the retained profits to invest and expand output. As interest rate decreases, firms will find that the opportunity cost of investment will fall, so they are more likely to invest rather than saving.

(3) Firms will also expect higher sales as lower interest rates will raise consumer demand. The likelihood of earning more profits encourages firms to expand.

Question 27

Identify FIVE determinants in government expenditure

Answer 27

1. Policy objectives
2. Size of tax base and budget position
3. Demographics
4. The type of economic system and the nature of markets
5. Unexpected events (shocks to the economy)

Question 28

How does policy objectives influence government expenditure?

Answer 28

Policy objectives
- If a government wants to raise economic activity, it may decide to raise its spending to ensure that aggregate demand is sufficient to achieve a high level of employment and an increase in the country’s output.
- If a government wants to win political support, it may also decide to raise spending.

Question 29

How does the government’s budget position influence government expenditure?

Answer 29

• Higher government tax revenue will enable a government to spend more, without needing to borrow
• The government will be under pressure to cut spending (austerity) if it runs a big deficit.

Question 30

How does population influence government expenditure?

Answer 30

Pressure for a rise in government spending may come from an increase in the number of children (education) and/or an increase in the number of elderly people (healthcare).

Net immigration may increase the need to provide state-financed housing. However, immigrants of working age will provide tax revenue to finance the spending if some of the immigrants gain jobs in the country.

Question 31

How does economic system influence government expenditure?

Answer 31

Government spending as a percentage of GDP is likely to be higher in countries where the government thinks there is significant risk of market failure. In such countries, governments are likely to provide, for example, state-financed education and healthcare.

Government spending will be higher in planned economoy, as goods and services are allocated by the public sector.

Question 32

How does unexpected events (shocks) influence government expenditure?

Answer 32

A government will usually spend more after natural disasters, such as damage caused by a hurricane. It will also spend more during a military conflict.
- For example, Eurozone governments raised spending significantly to counter the coronavirus crisis during 2020. Their combined budget deficits reached almost €1tn (€976bn), which represent a 10 times increase compared to 2019, and equal to 8.9% of GDP in 2020.

Question 33

Identify THREE determinants in net exports (NX)

Answer 33

1. Relative price competitiveness
2. Quality competitiveness
3. Aggregate demand of domestic and foreign countries
4. Trade policies

Question 34

How does relative price between dosmetic country and foreign country influence net exports (NX)?

Answer 34

For example, for the US,

If the price of US goods is relatievly higher compared to other countries, and if the demand for US goods is price inelastic, then expenditure on US goods will increase. This is because the quantity demanded will decrease by a smaller percentage. As a result, US exports hence NX will increase
P↑↑↑, Qd↓ ⇒ Expenditure (Revenue) ↑↑

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On the other hand, if the demand for US goods is price elastic, then expenditure on US goods will decrease. This is because the quantity demanded will decrease by a greater percentage. As a result, US exports hence NX will decrease
P↑, Qd↓↓↓ ⇒ Expenditure (Revenue) ↓↓

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记得把进口价格也说了 (higher US good price means imports become relatively cheaper)

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The relative price of US goods will be more higher if there is
1. an increase in its exchange rate (international price of its currency)
2. higher inflation relative to foreign countries (domestic price of its currency)
3. higher cost of production OR lower productivity relative to foreign countries

Question 35

How does relative Quality between dosmetic country and foreign country influence net exports (NX)?

Answer 35

An improvement in the competitiveness of the country’s products, due for example to innovations, improved marketing, increased investment and improved human capital will encourage exports

Question 36

How does AD abroad influence net exports (NX)?

Answer 36

1. Home country’s GDP and foreign country’s GDPWhen a country’s GDP rises, demand for imports usually increases. Similarly, when incomes rise abroad, demand for the country’s exports is likely to increase.
2. Interest rate in domestic country and foreign country
   
   • For example, higher interest rate in a foreign country relative to the domestic country will cause the domestic currency to depreciate, as hot money in search of higher returns flows into foreign country. This will encourage exports and raise NX.
   • However, higher interest rate in a foreign country also dampen foreign consumption and foreign investment hence foreign GDP. This means the demand for the domestic country’s exports falls, damping NX.
3. Confidence
4. Wealth

Question 37

How does trade policy influence net exports (NX)?

Answer 37

(1) Trade restrictions (removal or imposition)
(2) Export subsidies

Question 38

Explain why SRAS is upward sloping

Answer 38

1. The profit effect (sticky wage): As the price level (that is, the price of goods and services) increases, the price of factors of production such as wages do not change. So the price level rises, the gap between output and input prices widens and the amount of profit increases.
2. The cost effect: Although the wage rates and raw material costs remain unchanged in the short run, average costs may rise as output increases. This is because, for example, overtime payments may have to be paid and costs will be involved in recruiting more members. To cover any extra costs that may be involved in producing a higher output, producers will require higher prices.
3. The misinterpretation effect: Producers may confuse changes in the price level with changes in relative prices. They may think that a rise in the price they receive for their products indicates that their own product is becoming more popular. As a result they may be encouraged to produce more.

Question 39

Identify TWO major reasons for an upward shift of the SRAS curve

Answer 39

1. Production cost
   
   • Higher prices in factors of production (wages or raw material costs), SRAS shifts left.
   • Higher corporate tax rate or higher indirect tax rate, SRAS shifts up.
   • Higher expected inflation rate
2. Lower productivity

Question 40

Identify TWO major reasons for an upward shift of the SRAS curve

Answer 40

1. Production cost
   
   • Higher prices in factors of production (wages or raw material costs), SRAS shifts left.
   • Higher corporate tax rate or higher indirect tax rate, SRAS shifts up.
   • Higher expected inflation rate
2. Lower productivity
   
   • Deteriorated resource quality, e.g. more pollution so people are less healthier, malnutrition(营养不良)
   • Reduction in quantity of resources (supply-side shocks), e.g. natural disasters such as earthquakes and hurricanes

Question 41

Explain the Keynesiasn LRAS curve

Answer 41

Keynesians often represent the LRAS curve as perfectly elastic at low rates of output, then upward sloping over a range of output and finally perfectly inelastic. This is to emphasize their view that, in the long run, an economy can operate at any level of output and not necessarily at full capacity (Y1).

• Elastic段: When output and hence employment are low, firms can attract more resources without raising their prices. There is time for input prices to change but, due to the low level of aggregate demand, they do not. For example, when unemployment is high, the offer of a job may be sufficient to attract new workers.
• Y to Y1 段: As output rises from Y to Y1, firms begin to experience shortages of inputs and bid up wages, raw material prices and the price of capital equipment.
• Inelastic 段: When output reaches Y1, the economy is producing the maximum output it can make with existing resources.

Question 42

Explain the neoclassical LRAS curve

Answer 42

The LRAS curve is a vertical line as the neoclassical economists believe thatiIn the long run the economy will operate at full capacity.
People form rational expectation and the actual price level = expected inflation level

Question 43

Give 3 reasons for changes in the quantity of factors of production, which can cause a shift in LRAS and SRAS

Answer 43

• Net immigration: Net immigration will increase the size of the labour force if the immigrants are of working age.
• An increase in the retirement age: This will increase the size of the labour force. A number of countries have raised the age at which people can receive a state pension and some of these countries plan to raise it even further in the future as life expectancy increases.
• More women entering the labour force: The proportion of women who work varies from country to country. For example, in 2020, only 21% of women of working age were in the labour force in Saudi Arabia, while in Norway the equivalent figure was 72%.
• Net investment: If gross investment (total investment) exceeds depreciation (capital goods that have to be replaced because they have become worn out or out of date) there will be additions to the capital stock.
• Discovery of new resources: The discovery of, for instance, new oil fields or gold mines can increase a country’s productive potential.
• Land reclamation (the creation of new land from the sea): For instance, in recent years, Dubai has added considerably to its land area by reclaiming land on which it has built apartments, hotels, marinas, theme parks and beaches.

Question 44

Give 2 reasons for changes in the quality of factors of production, which can cause a shift in LRAS and SRAS

Answer 44

• improved education and training – this will increase the skills of workers and so raise labour productivity
• advances in technology – these both reduce costs of production and increase productive capacity.

Question 45

Explain an equilibrium of an economy

Answer 45

• 第一段：An equilibrium of an economy is when there is no tendency for the macro-economy to change. It occurs when the size of total expenditure, aggregate output and national income are equal to each other and they are stable.
• 第二句：It can be illustread by the point where the AD and AS curves intersect, as illustrated below: (然后加上一个AS-AD的图）
• 第二段：If the price level was initially below P0 at P1, there would be macro disequilibrium. The excess demand would push the price level back up to the equilibrium level. If the price level was above P0 at P2, some goods and services would not be sold and firms would have to cut their prices. （记得在你的图上面，画两条横线，一条在equilibrium price level P0上，一条在P0之下）
• 第二句：the aggregate price level will adjust until it reaches P0, so P0 is the equilbrium price level, the corresponding output is the equilibrium output.

Question 46

Quick test: higher exchange rate一定会带来lower AD吗？

Answer 46

不一定。depends on PED of imports and exports.