2.2 Variations in economic activity, aggregate demand and aggregate supply Flashcards
What is aggregate demand
the total spending on goods and services in a period of time at a given average price level
relationship between average price level and real output
Why does the AD curve have a negative slope
the total demand from all sectors within the economy
Consumption, investment, government spending and foreign sector
as the average price level of the economy falls, the level output of all these sectors increase
What happens as the average price level falls
purchasing power of income and wealth (C + I + G) increases
interest rates decrease so there is more C, I and G
exchange rates of currency will also decrease, the currency depreciates and so there is more exports and less imports
therefore AD will increase
Four components fo AD
Consumption
Investment
government spending
foreign sector
What is consumption
the total spending by consumers/household sector on domestic goods and services
durable goods - used over a period of time like cars
non-durable goods - used over a short period of time, rice, toilet paper
Investment
addition of capital stock to the economy carried out by firms
replacement investment - spending on capital to maintain productivity of existing capital
induced investment - spending on capital to increase output due to an increase in demand in the economy
Government spending
the spending on health, education, law and order, defense, transport, housing…. carried out by the federal, state and local government
the amount they spend depends on the governments policies and objectives
Net exports
exports (X) - domestic goods and services bought by foreigners = results in an inflow of exports revenue to the country
Imports (M) - goods and services brought from foreign producers = results in an outflow of import expenditure
AD =
C + I + G + (X - M)
what changes consumption
changes in consumer confidence
changes in interest rates
changes in wealth
changes in personal income taxes
changes in household indebtedness
what happens when consumer confidence is high
consumption increases
AD will increase
what happens when consumer confidence is low
C will fall
AD will fall
What happens when interest rates are high
households save more and borrow less,\
c decreases and AD drops
what happens when interest rates fall
households save less and borrow more
C increase
AD increases
what happens when household wealth increases
C increases
AD increases
what happens when wealth is lower
C decreases
AD decreases
what is disposable income
the income left after taxes have been deducted
what happens when personal income decreases
households have more disposable income increases
C increases
AD increases
what happens when personal income taxes increases
households have less disposable income
C decreases
AD decreases
what happens when household is in more debt
less income to spend
c decreases
AD decreases
what happens when household has less debt
households have more income to spend
C increases
AD increases
What factors change investment
interest rates
business confidence
technology
business taxes
level of corporate indebtedness
what happens when interest rates change
Interest rates increases
business borrow less
I decreases
AD decreases
when interest rates fall
business borrow more
I increases
AD increases
what happens when business confidence changes
business confidence high
I increases
AD increases
when business confidence is low
I decreases
AD decreases
usually in recession s
what does changes in technology
improvements in technology has higher productivity, I increases and AD increases
deterioration in technology, fall in productivity , I decreases and AD decreases
what happens when business taxes change
when business taxes fall
I and AD increases
when business taxes rise
I and AD decreases
what happens when the level of corporate indebtedness changes
the less debt businesses accumulate, the more they can spend on investment
I and AD increases
the more debt businesses accumulate, the less they can spend on investment
I and AD decreases
What factors affect government spending
political priorities
economic priorities
What changes political priorities
election campaign promises
national security issues
austerity measures - claims to balance the government budget deficit
general welfare of society
foreign policy issues - aid given to developing countries
What are economic priorities
boosting economic growth
G and AD will increase
Maintain stable rate of inflation
G and AD will decrease
Lowering unemployment rate
G and AD will increase
Achieving a more equitable distribution of income and wealth
G and AD will increase
what government policy tools affect AD
fiscal policy and monetary policy
what is fiscal policy
government policies relating to the use of taxation and government expenditure to influence AD
- direct taxes
- indirect taxes
- government expenditure
what is monetary policy
government policies relating to the use of supply of money and the level of interest rates in an economy to influence AD
Lower interest rates and greater supply of money would increase AD
what happens when trading partners experience economy growth
foreign demand for our G and S will increase
X and AD increases
what happens when trading partners experience recessions in economy activity
foreign demand for our G and S will decrease
X and AD decrease
what happens when domestic national income increases
consumer increase their demand for all sort of goods and services so demand for M also increased
M increases, AD decreases
what happens when domestic national income decreases
consumers decreases their demand for foreign goods
M decreases and AD increases
what happens when the currency rises (appreciates)
imports become cheaper - M increases
Exports become more expensive and decrease
AD decreases
what happens when the currency falls (deppreciates)
imports become more expensive - M decreases
exports become cheaper X increases and AD increases
what happens when trading partners adopt more free trade policies
demand for X increases so AD increases
what happens when trading partners adopt more protectionist trade policies
Demand for X decreases and so does AD
what is aggregate supply AS
the total amount of goods and services that all industries in the economy will produce at every given price level
it is the sum of the supply curves of all the industries in the economy
what is the short run
the period of tine where prices of factors of production are fixed - particularly wages for labour are fixed
why does the SRAS slope upwards
to produce more output, firms have to give workers more incentives to work more, pay more wages
cost of production rise and are passed on to consumers in the form of higher prices, average price level in the economy rises
what causes shifts in SRAS
changes in indirect tax and subsidies
supply shocks
changes in the prices of factors of production
what happens if FAPs Increase
cost of production will increase, SRAS will decrease
what happens if FOPs decrease
cost of production will decrease and SRAS will increase
what happens if indirect taxes or subsidies decrease
cost of production will increase
SRAS will decrease
what happens if indirect taxes decrease and subsidies increase
cost of production will decrease and SRAS will increase and shift to the right
what are supply shocks
wars, terrorist attacks, natural disasters
negative, SRAS will derease
major technological advancement, positive supply shock, SRAS will increase
what are the two types of long run aggregate supply
supply side economists
demand side economists
what do the supply side economists believe
monetarists
‘supply creates its own demand’
they believe in the efficiency of market forces
they believe hat governments should not intervene but only creates the conditions for markets to operate freely and efficiently
what do demand side economists believe
Keynesian school of though
demand create its own supply
governments should intervene in the allocation of resources in the economy to affect AD and smooth out short term fluctuations
monetarists supply side LRAS curve
vertical line at the level of potential output (full employment_ Yfe. because AS in the long run is independent of the price level
what does the monetarists LRAS curve represent
represents the potential output that could be produced if the economy were operating at full capacity
full employment does not mean there is zero unemployment
wages and prices are fully flexible and will adjust freely
any attempt to change AD will only affect the price level and not on the level of real `GDP
asserts that the potential output is based solely on the quantity and quality of the factors of production and not on the price level
what does the Keynesian LRAS look like
the curve haas three sections because of wage/price downward inflexibility and different levels of spare capacity in the economy
what does section one of the Keynesian model show
does not distinguish between short run and long run only AS
the AS curve is perfectly elastic at low levels of economic activity because of wages/prices downward inflexibility (people will not accept cuts)
producers in the economy can raise their levels of output without incurring higher average costs because of spare capacity
there are high levels of unused factors such as unemployment and under used capital
should there be a greater need for output, these can be used to their fullest capacity at constant average costs.
what happens in section two of the Keynesian model
much less spare capacity
economy is approaching full em0ployment
if firms want to increase aggregate supply, they have to bid for scarcer resources and so the cost of production will begin to rise
firms will pass these higher costs on to consumers in the form of higher prices
what happens in section three of the Keynesian model
economy has reached its productive capacity - no more spare capacity - prosecuting at full employment level of output Yfe
Any further increase in AD will only lead to inflation and a rise in the average price level
what factors shift LRAS
changes in quantity and or the quality of factors of production
- improvements in efficiency new technology reductions in unemployment institutional changes investments in infrastructure discovery of new natural resources larger workforce improvements in education, training and work practices
what is the Keynesian mode known to be
sticky wage model
what is the new classical known to be
flexible wage model
how do shifts in LRAS occur
caused by changes in the quality and quantity fo FOPS, therefore changes the productive capacity and productive output of the economy as a whole
similar to shifts in the PPC
what are supply side policies
government policies aimed to increase the quantity of FOPS and or improve the quality of GFOPS, increases the proactive capacity
what are the two types of supply side policy
interventionist and market - based
what is the interventionist policy
based on the ideas that the government has a fundamental role to play in actively encouraging economizing economic growth
examples of interventionist policies
investment in human capital, infrastructure, technology
industrial policies that promote growth like tax cuts and subsidization
what is a market based policy
they focus on allowing markets to operate more freely with minimal government intervention . these may also be described as insertional changes as they affect the structure, institutions and rules that govern economic stakeholders
what are examples of market based
policies to encourage competition
larbour market reforms
incentive related policies to increase workers incentive to work
what is the aim of supply side policies
they aim to positive ely affect the production side of an economy by improving the institutional framework and the capacity to product therefore shift LRAS curve to the right
factors to consider when evaluating supply side policies
time lags
ability to create employment
ability to reduce inflationary pressure
the impact on economic growth ,
impact on government budget
effect on equity
effect on the environment
what does the SRAS represent
the output produced by the economy - it is equal to AD and the economy is also at its full employment level of output. Because AS is equal to AS, there is no upward or downward pressure on the price level, thus, there is no inflationary or deflationary pressure.
what happens if there is an initial change such as AD increasing
could be caused by the government cutting taxes and increases government spending
AD will shift to the right
economy will experience a temporary inflationary gap where the output goes beyond Yfe and the average price level begins to rise, there is a short run equilibrium but a long run disequilibrium
in the long run, because of the rise in average price level, the costs of production will begin to rise and SRAS will shift to the left, bringing the economy back to full employment level of output at Yfe but with an even higher price level of P3
what happens if there is an initial change of AD decreasing
could be due to consumer drop in confidence
Ad curve shifts left , average price level beings to fall and economy experiences a deflationary gap where actual output Y2 is less than potential output Yfe
in the long run, due to the fall in average price level, the costs of production begins to fall and so SRAS increases to SRAS1, bringing economy back to full employment levels of output Yfe at one even lower price level
what do new classical economists argue
that the economy will always move automatically to its long run equilibrium - without any government intervention
while there may be short-term fluctuations in output, the economy will always return to the full employment level of output in the long run
they believe that shifts in the LRAs will change the long run equilibrium and change the full employment level of output.
shifts in the LRAs represent shifts in the economies productive capacity and can only occur in the long run and only due to changes in the quantity or the quality of FOPs
when can the economy be at an equilibrium in the keynesian model
at any level of real output where AD intersects AS
what do you say if the output is less than the full level of output
there is a recessionary gap
what do keynesian believe about recessionary gaps
they belie that economy can remain stuck in this deflationary gap because the economy is still at equilibrium and it wont necessarily self correct or move automatically towards full employment level of output.
what are the implications about Keynesians believing that the economy can remain stuck in a deflationary gap
government needs to intervene and use demand side policies to increase AD and close this deflationary gap by pushing output closer to full employment levels (Yfe). Also due to the existence of spare capactiy in the economy, producers can employ unused FOPs to increase output with no increase in costs - no inflationary pressure
what happens if the real output is very close to full employment
there is an inflationary gap as any further attempts to increase AD from AD1 to AD2 will then be inflationary because the economy is approaching full employment and there is less spare capactiy - so to increase output producers must compete for scarcer resources and hence costs of production rises - rising average price level
what is a demand side policy
policies used to influence the level of aggregate demand
can either be fiscal policies or monetary policies
two types of demand side policies
fiscal and monetary policies
what is a fiscal policy
use of taxes and government spending to influence the AD
what is a monetary policy
use of interest rates and supply of money to influence the level of AD
what is the aim of an expansionary policy
to increase AD and lower unemployment and encourage economic growth
what is the aim of contractionary policies
to decrease AD and slow down the rate of inflation
what do changes in LRAS have on the keynesian model
if LRAS increases - the impact of the economy will depend on the initial equilibrium
if operating below full employment level of output, then an increase in LRAS will have no effect on equilibrium output
if operating close to or at full employment level of output, then an increase in LRAS will help reign in the inflationary pressures of being close to or at full employment
What is MPS
the marginal propensity to save
what does MPS mean
the proportion of an increase in income that will be saved (leakage)
what is MPM
the marginal propsentiy to import
what does MPM mean
the proportion of an increase in income hat will be spend on imports (leakages)
what is MRT
marginal rate of taxation
what does the MRT mean
the proportion of an increase in income that will be taxed
what is the MPW
marginal propensity to withdraw
how is MPW measured
the sum of MPS, MPM and MRT
what is the MPC
change in the consumption spending as a result of a change in income
how to calculate MPC
1 - MPW
1 - (MPS + MPM + MRT)
MPC + MPS + MPM + MRT =
1
what is the keynesian multiplier
1 / 1 - MPC
what is the multiplier effect
if a government decides to fill a deflationary gap by increasing its own spending, the final increase in AD will actually be greater than the amount of spending
will result in a proportionately larger increase in national income
What is aggregate demand
the total spending on goods and services in an economy at a given price level over a period of time
Conumsption
Investment
Government spending
Exports - imports
Draw aggregate demand curve
powerpoint
What is consumption
the total sending by consumers on domestic goods and services
What can consumption take place on
durable and non-durable goods
What are durable goods
goods that are used over a long period of time (cars)
What are non durable goods
goods that are used up immediately on in a short period of time
food, toilet paper
What are non price determinants of consumption
Changes in income
changes in wealth
changes in consumer confidence
changes in interest rates
Explain three factors that could cause a decrease in consumption in an economy (10 marks)
Definiton
diagram
factor 1
factor 2
factor 3
What is government spending
money spent by governments at a variety fo levels on a wide variety of goods and services
What factors affect government spending
objectives/policies eg austerity measures
business cycle
unexpected events
What is investment
investment is the additional spending on capital stock by businesses
Capital stock includes factories, machines, offices and computers
What are the two types of investment
replacement investment (existing capital ) induced investment (new capital)
What factors affect investment
interest rates
income
technological change
business confidence
Draw a diagram for investment and interest rates
as investment goes up, interest rates go down
What are net exports
exports - imports
What are exports
the total value of goods and services that are bought by foreigners.
What are imports
the total value of goods and services bought from foreign countries
What factors affect net exports
change rates domestic national income foreign national income trade policies inflation
What is aggregate supply
the total amount of goods and services industries will produce at any given price level
What is long run aggregate supply
the period of time where the rices of the factors of production are variable, there are two theories about the LRAS curve
What do new classical ‘monetarists’ believe abotu LRAS
Supply side economists believe that
- there should be the very minimum amount of government intervention to allocate resources efficiently
- supply side factors are more influential at decreasing unemployment
What is the new classical LRAS like
LRAS curve is perfectly inelastic
represents potential output if economy was operating at full capacity
Yf is the full employment level of output
Price has no influence over quantity supplied
Potential output Is based on quality and quantity of factors of production
any deviation from this line is temporary
What are the three phases of Keynesian AS
no difference between long run and short run
- perfectly elastic - firms can use spare capacity to increase output without increasing price levels
- Spare capacity is used up - higher prices are needed to cover higher costs for scarce resources
- perfectly inelastic - all factors of production are being used, increase in price does not affect output
With the help of diagrams explain the difference between the Keynesian LRAS and the New classical LRAS (10 marks)
Plan
