2.2 Aggregate Demand and Aggregate Supply Analysis

Question 1

What is aggregate demand?

Answer 1

-Aggregate demand is the total demand in the economy.
- It measures spending on goods and services by consumers, firms, the government and overseas consumers and firms.

Question 2

How can the downward slope of the AD curve be explained?

Answer 2

• Higher prices lead to a fall in the value of real incomes, so goods and services
  become less affordable in real terms.
• If there was high inflation in the UK so that the average price level was high,
  foreign goods would seem relatively cheaper.
  -Therefore, there would be
  more imports, so the deficit on the current account might increase, and AD
  would fall.
• High inflation generally means the interest rates will be higher. This will
  discourage spending, since saving becomes more attractive and borrowing
  becomes expensive.

Question 3

What causes shifts in the AD curve?

Answer 3

• by changes in the components of AD (C, I, G or X-M)

Question 4

When does the AD curve shift outwards?

Answer 4

• A rise in economic growth causing a shift in AD it may occur when:
• Consumers and firms have higher confidence levels, so they invest and spend
  more, because they feel as though they will get a higher return on them.
  -This is affected by anticipated income and inflation.
• If the Monetary Policy Committee lowers interest rates, it is cheaper to
  borrow and reduces the incentive to save, so spending and investment
  increase.
  -However, there are time lags between the change in interest rates
  and the rise in AD, so this is not suitable if a rise in AD is needed immediately.
• Lower taxes mean consumers have more disposable income, so AD rises.
• An increase in government spending will boost AD.
• Depreciation in a currency means M is more expensive, and X is cheaper, so
  AD increases.
  -A decline in economic growth in one of the UK’s export markets
  means there will be a fall in X, so AD falls.
• In the UK, most people own their houses. This means that a rise in the price
  of houses makes people feel wealthier, so they are likely to spend more.
  -This is the wealth effect.
• If credit is more available, then spending and investment might increase.
  -Recently, since the financial crisis of 2008, banks have been less willing to
  lend due to the risks associated with lending.

Question 5

What is aggregate supply?

Answer 5

• Aggregate supply shows the quantity of real GDP which is supplied at difference price levels in the economy.

Question 6

Why is the AS curve upward sloping?

Answer 6

• because at a higher price level, producers are willing to supply more because they can earn more profits.

Question 7

What leads to a movement along the AS curve?

Answer 7

• Only changes in the price level, which occur due to changes in AD, lead to
  movements along the AS curve.
• If AD increases, there is an expansion in the SRAS
• If AD falls, there is a contraction in SRAS

Question 8

What causes shifts in the SRAS curve

Answer 8

• shifts occur when there are changes in the conditions of supply
• The cost of employment might change, e.g. wages, taxes, labour productivity
• The cost of other inputs e.g. raw materials, commodity prices, the exchange rate if products are imported
• Government regulation or intervention, such as environmental laws and taxes, and business regulation. Business regulation is sometimes called ‘red tape’.

Question 9

How do the factors which affect long-run AS distinguish them from those
which affect short run AS?

Answer 9

• The SRAS curve only covers the period immediately after a change in the price level.
• It shows the planned output of an economy when prices change, whilst the cost of production and productivity of the factor inputs are kept constant.
• These could be wage rates or how technologically advanced capital is, for example.
• The curve is upward sloping because supply is assumed to be responsive to a
  change in AD, which is reflected in the price level
• The LRAS curve shows the potential supply of an economy in the long run.
• This is when prices, and the costs and productivity of factor inputs, can change.
• it can show the economy’s productive potential.
• the curve is vertical, because supply is assumed not to change as the price
  level changes.
• A right-ward shift in the LRAS curve shows economic growth.

Question 10

When does macroeconomic equilibrium occur?

Answer 10

• The economy reaches a state of equilibrium when the rate of withdrawals = the rate of injections.
• This is equivalent to the point where AD = AS.

Question 11

How do both demand-side and supply-side shocks affect the macro economy?

Answer 11

• At a price above equilibrium, there will be excess supply.
• At a price below equilibrium, there will be excess aggregate demand, in the short run.

Question 12

How do supply side shocks affect the macro economy?

Answer 12

• If the economy becomes more productive, or if there is an increase in efficiency,
  supply will shift to the right.
• This lowers the average price level and increases national output
• If AS shifts inwards, price increases and national output decreases.

Question 13

How do demand side shocks affect the economy?

Answer 13

• If firms have less confidence or there is a recession, AD might shift inwards.
• This causes the price level to fall and national output to fall
• If AD increases, the price level and level of national output both increase.