1- How The Macroeconomy Works

Question 1

Define Aggregate Demand?

Answer 1

Aggregate demand is the measure of the total demand of goods and services within the economy at a given price level over a period of time

Question 2

Formula of AD?

Answer 2

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

AD=GDP

Question 3

What shifts AD curve?

Answer 3

Any factor that INCREASES C,G, I or X (Or decreases M) at any given price level, shifts AD curve to the right and vice versa

Question 4

1st factor- consumption

Key influences that increase or decrease consumption?

Answer 4

• imports -leakage
• Taxations- leakage
• savings
• income
• wealth
• distribution of income and wealth
• interest rates
• credit availability
• consumer confidence

Question 5

What affect do imports and taxation have on consumption?

Answer 5

Both are leakages and so causes consumption to fall, thus decreasing AD

Question 6

Whats the relationship between savings and consumption?

Answer 6

Savings are a key influence as the opportunity cost of savings is consumption and vice versa. There is an inverse relationship between them. The main determinants of savings are:
> income: if wages rise, people can afford to put aside more money for the future
> interest rates: increased interest rates lead to greater reward for savers
> planned purchases: if individuals have specific major purchases planned, eg house or a car, then they will save beforehand
> future needs: if individuals expect a greater need for money in the future, such as for starting a family, they will save in anticipation of this need. If lower need is expected, then savings will be reduced

Question 7

What affect does income have on income and so AD?

Answer 7

• income is the flow of money each year, earned by employment
• initially, high income enables consumers to buy more good and so increases consumption and so AD
• consumption tends to be based on DISPOSABLE INCOME(income after deductions such as income tax) rather than gross income (before tax)
  BUT We look at the LIFE CYCLE THEORY OF CONSUMPTION:
• assumes that CURRENT income is not the main influence on consumption
• this theory assumes that people look at expected future income and plan consumption over their lifetime eg working consumers put aside savings into pension funds, thus reducing consumption but then have money for retirement
• change in income and change in consumption are proportional

Question 8

What effect do interest rates have on income and so AD?

Answer 8

• Interest rates are the reward for savings and cost of borrowing
  1) high interest rates can encourage SAVINGS and thus reduce consumption
  2) high interest rates mean borrowing is more expensive. This affects spending on consumer durables people often borrow to buy these items
  3) higher payments on mortgages and loans can also lead to less money for consumption of everyday items

Question 9

What effect does credit availability have on income and so AD?

Answer 9

• ready availability of credit means people can easily spend more than their incomes, thus increasing consumption and so AD
• banks are now more reluctant to give credit and so consumption has fallen

Question 10

What effect does consumer confidence have on income and so AD?

Answer 10

Less confidence- worried for future- consumption decreases- AD decreases

More confidence- expect future economic growth- consumption increases- AD increases

Question 11

What effect does wealth have on income and so AD?

Answer 11

Finish fc

Question 12

What effect does the distribution of income and wealth have on income and so AD?

Answer 12

Finish fc

Question 13

2nd factor- Investment

Define gross investment?

Answer 13

Gross investment is total spending on capital goods in terms of AD

Question 14

2 reasons why firms would decide to invest?

Answer 14

Replacement investment- replacing assets that are no longer usable. This can arise from DEPRECIATION (where an asset has worn out over time) or OBSOLESCENCE (where technical progress has led to an asset being out of date)
New investment-
Adding to the stock of capital goods in order to increase productive capacity

Gross investment=replacement investment+ new investment

When firms confidence is low, firms may choose not to replace capital that wears out

Question 15

What are the 2 determinants of Investment?

Answer 15

1- the marginal efficiency of capital (MEC)

2- the accelerator theory of investment

Question 16

What is the marginal efficiency of capital (MEC)?

Answer 16

Every planned investment in capital goods has an expected marginal efficiency. This is the expected percentage return on the money invested.

See book for calculations

Total investment depends on the expected marginal efficiency of capital goods and the interest rate charged for borrowing

Question 17

What is the accelerator theory of investment?

Answer 17

The theory assumes that investment is based on BUSINESS CONFIDENCE
- in times of economic growth, firms invest more heavily in capital goods but if growth falls, they will cut back severely in order to avoid having expensive, unused equipment. This leads to ACCELERATED changes in investment, with major increases in times of optimism but DRAMATIC falls when firms confidence is low

Accelerator=changes in investment/ change in AD or real GDP

Question 18

What is government spending determined by?

Answer 18

Government spending is assumed to be independent of National Income. Its level is determined by political decisions, policy requirement and macroeconomic policy

Question 19

What are net imports (exports- imports) dependant on and whats the difference between the two?

Answer 19

-exports and imports will be determined by the relative quality of UK products in comparison to those of other countries
- they also depend on relative price levels in different countries and exchange rates.
However the key difference between them is:
- exports depend on levels of income in other countries
- whereas imports depend on the UK’s level of income

Question 20

Multiplier effect?

Answer 20

Blah blah blah

Question 21

Multiplier effect

Answer 21

Blah blah blah

Question 22

Multiplier effect

Answer 22

Blah blah blah

Question 23

Define Short run Aggregate Supply?

Answer 23

AS is the total quantity of goods and services that firms are willing and able to produce at a given price level over a given period of time

Question 24

Why is the supply curve upward sloping?

See diagram in book

Answer 24

The supply curve is upward sloping because

• firms are rational and profit maximising so if price level increases, they will supply more goods in order to increase their profits
• cost of production rises in short run, so firms will produce and sell more at higher prices to compensate for higher unit of costs

Question 25

The supply slope becomes steeper as real GDP increases. Why?

Answer 25

The slope becomes steeper as real GDP increases. This is because there is a maximum capacity output that the economy can produce in the short run- shown by the PPF diagram

Question 26

Determinants of short run AS?

Answer 26

Any factor that makes it cheaper to supply products shifts AS to the right. Any factor that makes it more costly to supply products shifts AD to the left. Main determinants are:

• wage costs
• raw materials and costs
• technology
• productivity of factors of production
• indirect taxes and subsidies

Question 27

Determinants of SRAS explained?

Answer 27

Wage costs- increase in wages decreases AS

Technology-improvements in technology enable firms to produce more cheaply, thus increasing AS

Raw materials and other costs- increases in costs will decrease AS. Decrease in costs will increase AS

Productivity of factors of production- if firms increase efficiency of production, then average costs fall and AS Increases

Indirect taxes and subsidies-if government increases indirect taxes eg VAT, it acts like an increase in costs and thus decreases AS. In contrast, subsidies will lead to an increase in AS as they act like a decrease in cost of supplying goods

Question 28

Whats the difference between LRAS classical graph and the Keynesian graph?

Answer 28

Classical economists believe that the market will always clear. If there are shortages or unused resources, the market will adjust until these shortages/surpluses are eliminated. Consequently, the economy will work at its full capacity. As this is a fixed limit, the LRAS is vertical

Keynesian economists believe the market does not adjust so freely and so it is possible to have unemployed resources in the long run

Question 29

Determinants of LRAS?

Answer 29

Technology- advanced technology increases productive capacity and therefore increases LRAS

Productivity- more efficient factors, such as highly trained labour, increases LRAS

Attitudes- factors such as the work ethic, morale and flexibility of the workplace can influence capacity. More capacity increases LRAS

Entreprise- a greater willingness to be entrepreneurial and take risks increases a country’s capacity

Factor mobility- flexible factors of production help an economy to adapt to changes and grow, whereas immobile factors restrain growth

Economic incentives-high rewards can motivate people to be more entrepreneurial and to improve their skills. Low tax rates and grants can encourage use of all four factors

Infrastructure- utilities such as transport links, telecommunications, health and education contribute towards increasing LRAS

The institutional structure of the economy- efficient support institutions, such as banking system, can help to improve a country’s LRAS

Question 30

Define macroeconomic equilibrium?

Look at diagram in book

Answer 30

Macroeconomic equilibrium is a state where there is no tendency for national income or real GDP to change. It occurs when:

AD=AS
planned injections= planned leakages
Planned I+G+X. = planned S+T+M

Question 31

Define economic shocks?

Answer 31

Economic shocks are sudden changes that affect the economic cycle. These may be:

• Demand Side shocks that affect AD
• Supply Side socks that affect AS

Shocks are usually short term factors but can trigger favourable or adverse changes in the economic cycle

Question 32

Examples of what can cause demand side shocks?

Answer 32

• boost in government spending prior to general election or a boom or recession in other countries that buy our exports

Question 33

Examples of what can cause supply side shocks?

Answer 33

• exceptionally good harvest, a dramatic rise in oil prices of a natural disaster

Question 34

Is a macroeconomy equilibrium what can the impact of changes in AD and AS curves depend on?

Answer 34

The final impact on changes in AD and AS will depend mainly in the shape of the AS curve

1) if AS is horizontal, then increase in AD will cause an increase in output but no increase in the price level
2) the flatter the AS curve, the greater the impact on AS
3) if AS is vertical, then an increase in AD will cause no increase in output but the price level will rise
4) the steeper the AS line , the greater impact on price level

Question 35

What is the circular flow of income?

Look at diagram in book

Answer 35

The circular flow of income shows how firms and households interlink in an economy.

The size of an economy(Nation income or GDP) can be measured through the circular flow of income. The quantity produced must equal the level of expenditure by households, which must equal the amount paid to the factors of production. Thus

Output of products= household expenditure= incomes of factors of production

Output=expenditure= income

Question 36

Where would u find the equilibrium in the simple circular flow of income model

Answer 36

The equilibrium will be found when the flow from firms to household and the flow from households to firms is equal. More complex has leakages and injections

Question 37

What are the leakages?

What are the injections?

Answer 37

Leakages are factors that lead to income not being used for consumption in the circular flow. These are
- savings
- taxations
- imports
Injections are factors that lead to additional income for firms, in excess of that received from consumption. These are:
- investment
- government spending
- exports

Question 38

Define savings?

Answer 38

Savings is when households do not spend all of their money on consumption because they choose to set aside money for the future

Question 39

Define taxations?

Answer 39

Taxations is when money is taken from households by the government, typically to finance items of government expenditure eg education, but also possibly to reduce consumer spending

Question 40

Define imports?

Answer 40

Imports are goods and services produced in other countries, then brought to the UK in exchange for currency

Question 41

Define exports

Answer 41

Exports are goods and services produced in the UK, then sent to other countries in exchange for currency

Question 42

Define investment?

Answer 42

Investment is where firms spend money within the economy in hopes of making a profit

Question 43

Define government spending?

Answer 43

Government spending is where money is put into the circular flow through government spending on providing goods and services

Question 44

Define net exports?

Answer 44

Pound value of all goods and services produced in the UK shipped to other countries MINUS the value of goods and services imported from other countries

Question 45

When can the national income or real GDP decline or expand?

Answer 45

If planned leakages exceed planned injections, then on balance, money leaves the circular flow and so national income declines

If planned injections exceed planned leakages, then more money enters the circular flow and so national income expands