2.2 Aggregate Demand And Aggregate Supply

Question 1

What is aggregate demand?

Answer 1

Total value of all goods and services demanded in economy per time period.

Question 2

What does the AD curve show?

Answer 2

Real national output that is purchased at each price level per time period. Has a negative slope because when general level of prices is high the level of AD tends to be low.

Question 3

What are the three reasons why the demand curve is downwards sloping?

Answer 3

The Pigou wealth effect
Keynes interest rate effect
Mundell Flemings exchange rate effect

Question 4

What is the Pigou wealth effect?

Answer 4

For any given nominal value of income a lower price level allows households, firms and government greater purchasing power resulting in greater consumption, investment and government spending.

Question 5

What is Keynes’ interest rate effect?

Answer 5

A fall in general price level causes interest rates to drop thus boosting demand for money ceteris paribus. Results in great consumption, investment expenditure and government spending ie higher AD.

Question 6

What is Mundell Fleming’s exchange rate effect?

Answer 6

As general price level falls, interest rate also tends to fall, resulting in a depreciation of the exchange rate. Tends to increase demand for net exports because domestic products are cheaper thus boosting AD.

Question 7

What are the components of AD?

Answer 7

Consumption expenditure (C), investment expenditure (I), government spending (G), export earnings (X) and import expenditure (M).
AD = C + I + G + (X-M)

Question 8

What is consumption?

Answer 8

Total spending on goods and services by households in domestic economy per time period. It is the largest component of AD.

Question 9

What is investment?

Answer 9

Capital expenditure of firms in the economy. Results in a larger productive capacity in the long run.

Question 10

What is government spending?

Answer 10

Total expenditure on goods and services by the government.

Question 11

What are net exports?

Answer 11

Measures difference between the value of export earnings and import expenditure.

Question 12

What is disposable income?

Answer 12

Earnings after taxes have been accounted for ie. actual take home incomes that workers are able to spend.

Question 13

What do the determinants of AD do to the AD curve?

Answer 13

Refer to the factors that cause shifts in the AD curve.

Question 14

What are some facts that affect the level of consumption?

Answer 14

Consumer confidence
Interest rates
Wealth 
Personal income tax
Household indebtedness

Question 15

How does consumer confidence affect the level of consumption?

Answer 15

The more confident consumers are about the economy the greater the level of consumption will be. Consumer confidence is low during a recession and higher during a boom.

Question 16

How does interest rates affect the level of consumption?

Answer 16

Higher interest rates tend to reduce consumption as households with loans and mortgages have lower income to use at their discretion.

Question 17

How does wealth affect the level of consumption?

Answer 17

Changes in household wealth have a positive impact on the level of consumption ie. the wealthier households are the more they tend to consume.

Question 18

How does personal income tax affect the level of consumption?

Answer 18

If the level of disposable income fall due to higher income tax consumption will also fall ceteris paribus.

Question 19

How does household indebtedness affect the level of consumption?

Answer 19

The more debts that household have the less income they have for consumption.

Question 20

What are some factors that affect the level of investment?

Answer 20

Interest rates
Business confidence 
Technology
Business taxes
The level of corporate indebtedness

Question 21

How does interest rates affect the level of investment?

Answer 21

Higher interest rates tend to reduce investment because the cost of borrowing funds to invest will increase.

Question 22

How does business confidence affect the level of investment?

Answer 22

The greater the level of business confidence in the economy the higher the level of investment will be. Business confidence is high the the economy is in a boom.

Question 23

How does technology affect the level of investment?

Answer 23

Technological progress and the associated productivity gains will tend to boost the level of investment expenditure.

Question 24

How does business taxes affect the level of investment?

Answer 24

The lower the rate of taxes in the economy the more attractive investment becomes as firms are more able to make a return on their investment.

Question 25

How does the level of corporate indebtedness affect the level of investment?

Answer 25

The more debts businesses have the less money they have available for investment expenditure, indebtedness tends to increase during periods of rising interest rates or during an economic downturn when firms struggle to survive.

Question 26

What are factors that affect the level government spending?

Answer 26

Political priorities - government spending will vary depending on the political priorities.
Economic priorities.

Question 27

What are factors that affect the level of net exports?

Answer 27

Income of trading partners - due to globalisation and interdependence when a country suffers from economic downturn there are negative impacts on its trading partners.
Exchange rates - higher exchange rate tends to reduce the demand for exports as they become more expensive for foreign buyers.
Changes in level of protectionism - trade barriers such as tariffs and quotas raise the price of imports thus tending to reduce the demand for foreign goods and services.

Question 28

What is aggregate supply?

Answer 28

Refers to amount of real national output that firms are willing and able to produce at each price level. Measure of an economy’s potential output.

Question 29

What does the short run AS curve show?

Answer 29

Total planned national output at different price levels ceteris paribus.

Question 30

Why is the SRAS curve upwards sloping?

Answer 30

Higher prices attract more firms to raise their output level.

Question 31

What shifts the SRAS curve?

Answer 31

In the shot run a change in non price factors that affect AS will shift the SRAS curve.

Question 32

What are the non price factors which affect the cost of production?

Answer 32

Changes in resources prices
Changes in business taxes
Changes in subsidies
Supply shocks

Question 33

How do monetarists (new classical economists) differ in their view of the long run supply curve?

Answer 33

LRAS curve is vertical at the full employment level of output. Hence LRAS is independent of the price level as this represent the maximum potential level of national output of the economy per time period.

Question 34

What affects the LRAS curve?

Answer 34

The quantity and quality of factors of production affect the LRAS curve.

Question 35

How do Keynesians view the AS curve?

Answer 35

AS curve has three sections mainly due to the varying degrees of spare capacity in the economy.

Question 36

Why do Keynesians argue that wages are sticky downwards?

Answer 36

They believe in labour market inflexibility because:

• Firms may prefer to cut employment rather than wages because pay cuts can reduce worker morale and productivity.
• Existing employment contracts can also prevent wages from falling below the agreed level.
• Workers get used to a certain wage rate and are inflexible, through trade union action, in accepting pay cuts.
• It is not legally possible to cut wages below the national minimum wage even during a major economic downturn.

Question 37

How do Keynesians view the AS curve in different sections?

Answer 37

• Horizontal flat part of the curve up until Y1 until it starts to curve - spare capacity in economy, perhaps due to a recession, high unemployment and stick wages. Hence price level is stable even if the national output changes.
• The upwards sloping section shows increasing demand for resources and labour shortages, thereby causing the price level to rise as national output increases.
• At the full employment level of national output - vertically flat section - firms compete for limited resources as soon as the economy is at full capacity thereby forcing up the general price level even though the economy cannot produce beyond its productive capacity.

Question 38

What are some examples of things that will shift the LRAS curve?

Answer 38

Improvement in efficiency - higher productivity of resources will shift the AS curve the right.
New technology - technological process and innovations shift the LRAS curve rightwards.
Reduction in unemployment - a fall in the number of unemployed people means that the productivity capacity of the economy can increase thus shifting the AS curve to the right.
Institutional changes - better infrastructure such as improved roads and railways enhance the economy productive capacity this shifting the AS curve outwards.

Question 39

How can the quantity of factors of production be increased?

Answer 39

By discovering new supplies or by a larger workforce.

Question 40

How can the quality of factors of production be increased?

Answer 40

By improved education, training and work practices.

Question 41

What is equilibrium?

Answer 41

When AD is equal to AS.

Question 42

When does short run macroeconomic equilibrium occur?

Answer 42

When AD and the SRAS curve interest thus determining the actual level of real national output and the average price level.

Question 43

What is the full employment level of output?

Answer 43

Occurs when everyone who is willing and able to work is able to find employment. Exists at the point where unemployment is at its natural rate that can be maintained with price stability (zero rate of inflation).

Question 44

When does full employment exist?

Answer 44

When the economy is operating at full capacity ie. it is not possible to increase real national output as all resources are fully utilised.

Question 45

How can full employment be shown diagrammatically?

Answer 45

Full employment can be shown as a point on a production possibility frontier or on a AD AS diagram.

Question 46

According to monetarists where does long run equilibrium occur?

Answer 46

Believe long run equilibrium occurs at the potential or gull employment level of real national output.

Question 47

Why in reality can it be hard to know precisely the full employment level of output?

Answer 47

It can be impractical for every firms in the economy to operate at 100% capacity and it is not easy to determine the number of people who are voluntarily unemployed.

Question 48

How does the new classical model of equilibrium differ with short term fluctuations?

Answer 48

Any short term fluctuations in national output will only be temporary as market forces will restore equilibrium to the full employment level of national output.

Question 49

What happens when AD increase when long run equilibrium is at full employment level of national output?

Answer 49

If long run equilibrium is at the full employment level of national output Yf with the average price level at P1, an increase in AD from AD 1 to AD 2 increase the average price level from P1 to P2 causing AS to expand along the SRAS curve. This temporarily increase national output beyond its capacity and so raises production costs. Hence AS shifts from SRAS1 to SRAS2 causing the average price level to rise from P2 to P3 and the economy operating back at Yf.

Question 50

What do monetarists prefer to use to achieve economic growth?

Answer 50

Since monetarists believe that market forces will restore equilibrium they believes that demand side polices are ineffective in the long run. They prefer the use of supply side policies to shift the LRAS outwards to achieve economic growth.

Question 51

What changes long run equilibrium?

Answer 51

Caused by factors that shift the LRAS curve rightwards ie supply side policies. These include improved productivity of factors of production, technological process and incentives to stimulate inventions and innovations.

Question 52

Why do Keynesians believe market forces struggle to restore equilibrium?

Answer 52

Keynesians believes that wages are sticky downwards even during a recession so market forces struggle to restore equilibrium at the full employment level of national output without the need for government intervention (using expansionary fiscal and monetary policy). The Keynesian model of macroeconomic equilibrium suggests that the economy can be in equilibrium at any level of real national output where AD interests AS.

Question 53

Why do Keynesians think a increase in AD will not cause inflationary pressures?

Answer 53

According to the Keynesian economists an increase in AD along the flat horizontal part of the AS curve will not cause inflationary pressures if there is spare capacity int he economy.

Question 54

Why will the price level increase if AD increases on the vertically sloping upward part of the AS curve?

Answer 54

On the upwards sloping sections of the AS curve an increase in AD puts pressure on resources thus pushing up the average price level.

Question 55

If AS is perfectly price inelastic what happens if AD increases?

Answer 55

Any increase in AD simply increases the average price level as the economy cannot increase national output beyond the full employment level.

Question 56

How does the Keynesian model show that an increase in AD does not necessarily result in inflation?

Answer 56

Increases in AD need not necessarily cause inflation in the economy unless it is operating at or near its full employment level of output.

Question 57

When does a deflationary or recessionary gap occur?

Answer 57

A deflationary gap exists when the real national output equilibrium is below the full employment level of output. Without government intervention the economy can remain stuck in a deflationary gap.

Question 58

When does an inflationary gap exist?

Answer 58

If actual national output exceeds the full employment level of output ie AD increases along the vertical section of the LRAS curve causing an increase in the average price level.

Question 59

When does an inflationary gap occur?

Answer 59

If the government chooses to maintain full employment despite rising levels of AD putting pressure on the ability of the economy to supply goods and services. This will lead to demand pull inflation ceteris paribus.