3.2 Variations in economic activity Flashcards
formula for aggregate demand
Aggregate demand = C + I + G + (X − M)
What is aggregate demand (AD)?
The total demand for goods and services produced in an economy, consisting of consumption expenditure, government expenditure, investment spending, and net exports.
This is equivalent to GDP.
What is the formula for calculating aggregate demand?
Aggregate demand = C + I + G + (X − M)
C = consumption, I = investment, G = government spending, X = exports, M = imports.
What is the shape of the aggregate demand curve?
The aggregate demand curve is downward sloping.
This is similar to the market demand curve in microeconomics.
What happens to the quantity of goods and services demanded as the average price level falls?
The quantity demanded increases as the average price level falls.
This is illustrated by the movement from Y1 to Y2 in the aggregate demand curve.
What are the three reasons for the negative slope of the aggregate demand curve?
The three reasons are:
* The wealth effect
* The interest rate effect
* The net balance effect
Each effect contributes to increased demand as price levels fall.
What is the wealth effect?
As the average price level falls, the real wealth of participants in the economy increases, improving their ability to purchase goods and services.
The real value of assets such as property or stock increases.
What is the interest rate effect?
At lower price levels, interest rates decline, providing more disposable income to spend and increasing demand for output.
The incentive to save also decreases.
What is the net balance effect?
A lower price level makes goods and services cheaper for foreign countries, increasing demand for exports and decreasing demand for imports, improving the net trade balance.
This leads to a better overall economic position.
How does the aggregate demand curve differ from the demand curve in microeconomics?
The aggregate demand curve represents total output or real GDP, while the microeconomic demand curve measures the quantity of a single good.
Diminishing marginal utility does not apply to the AD curve.
What does the horizontal axis represent in the aggregate demand curve?
The horizontal axis represents the quantity of total output or real GDP.
This also reflects the total income of an economy.
True or False: The downward slope of the aggregate demand curve is influenced by diminishing marginal utility.
False.
The downward slope is due to the wealth effect, interest rate effect, and net balance effect.
Fill in the blank: Aggregate demand consists of consumption expenditure, government expenditure, investment spending, and _______.
spending on net exports.
This is part of the formula for aggregate demand.
What is the relationship between aggregate demand and GDP?
They are equivalent; aggregate demand is the same quantity as GDP.
Both measure the total economic output.
What causes movements along the AD curve?
Price level changes
Movements along the AD curve are similar to demand movements in microeconomics.
What can cause the AD curve to shift?
Changes in aggregate demand components
Aggregate demand is measured for the entire economy, unlike market demand.
What are the four components of aggregate demand?
- Consumption
- Investment
- Government spending
- Net exports
What happens to the AD curve when consumption increases?
The AD curve shifts rightward (outward)
This indicates an increase in aggregate demand.
What is one determinant of consumption that affects the AD curve?
Consumer confidence
Increased confidence shifts the AD curve rightward, while decreased confidence shifts it leftward.
How does unemployment affect consumption?
Increases concern about real incomes, potentially reducing consumption
Unemployment is closely monitored by governments.
What effect do real interest rates have on consumer spending?
Lower interest rates encourage spending; higher rates encourage saving
This influences the AD curve’s shift.
What is the difference between wealth and income?
Wealth refers to assets; income is earned through production factors
Rising asset prices can boost aggregate demand.
What effect do personal taxes have on consumption?
Lower taxes increase disposable income, shifting AD rightward
Example: 2017 Tax Cuts and Jobs Act.
How does household indebtedness impact future consumption?
Increases short-term consumption but may reduce future consumption due to debt repayment
This results in a rightward shift of AD followed by a potential leftward shift.
What do expectations of future price levels influence?
Current spending and saving behaviors
Inflation expectations lead to increased current spending.
What is the definition of investment in economics?
Spending by businesses to add to their capital stock for expansion
This differs from financial investment in markets.
What are the five factors that affect the level of investment?
- Interest rates
- Business confidence
- Technology
- Business taxes
- Level of corporate indebtedness
How do interest rates affect business investment decisions?
Lower rates encourage borrowing and investment; higher rates discourage them
This influences the AD curve’s shift.
What role does business confidence play in investment?
High confidence encourages investment; low confidence discourages it
This is a key indicator of economic health.
How does technology impact investment?
Innovation can lead to market growth and reduced production costs
However, it requires substantial upfront investment.
What effect do business taxes have on investment?
Higher taxes reduce available funds for investment, shifting AD leftward
Appropriate tax levels are crucial for encouraging business growth.
What is the significance of government spending in the economy?
It varies by political and economic priorities and can account for nearly 50% of GDP in developed countries
Government spending is critical for public services.
What factors affect net exports?
- Income of trading partners
- Exchange rates
- Changes in trade policies
How does the income of trading partners affect aggregate demand?
Higher incomes abroad increase demand for exports, shifting AD rightward
Economic interdependence means slowdowns can impact multiple economies.
What happens to aggregate demand when exchange rates appreciate?
Exports become less competitive, leading to a leftward shift of AD
Depreciation has the opposite effect.
What are some methods countries use to change trade policies?
- Tariffs
- Quotas
- Subsidies
- Exchange rate manipulation
True or False: Investment in the economy refers to investments in the stock market.
False
Economic investment refers to capital spending by firms.
What is aggregate supply (AS)?
The total quantity of goods and services produced in an economy (real GDP) over a specific time period at different price levels.
What characterizes the short run in macroeconomics?
The length of time during which resource prices stay relatively constant.
What is the relationship between output and selling price in the short run?
There is a positive relationship; higher prices lead to increased output as long as production costs remain constant.
What does a rightward shift in the short-run aggregate supply (SRAS) curve indicate?
Firms produce a larger quantity of real GDP at any price level.
What causes a leftward shift in the SRAS curve?
A decrease in the quantity of real GDP produced at any price level.
List the determinants of short-run aggregate supply (SRAS).
- Resource prices
- Government intervention
- Government subsidies
- Supply shocks
How do resource prices affect a firm’s productive capacity?
Changes in resource prices significantly impact the majority of firms within a country.
What happens if energy prices rise significantly?
The SRAS curve shifts to the left due to increased production costs for firms.
What is the effect of government regulation on firms?
It can either increase or decrease the amount of regulation, affecting firms’ revenue and investment capabilities.
How do government subsidies impact aggregate supply?
They can allow firms to expand productive resources, potentially shifting the SRAS curve outward.
What is a supply shock?
An event that affects the overall aggregate supply in a country, such as natural disasters or significant price changes.
What is the difference between the new classical and Keynesian schools of thought regarding aggregate supply?
New classical believes in market self-correction, while Keynesian emphasizes the role of government and the inflexibility of resource prices.
What does the new classical school assume about prices in the long run?
Prices of goods and resources are fully flexible and do not affect the level of output.
What does Keynes argue about resource prices during economic downturns?
Resource prices are downwardly inflexible, making it difficult for firms to cut costs by lowering wages.
What are the three sections of the Keynesian aggregate supply curve?
- Horizontal section (spare capacity)
- Upward sloping section (some competition for resources)
- Vertical section (full employment)
What factors shift the long-run aggregate supply (LRAS) curve?
Changes in the quantity or quality of land, labour, and capital.
Define ‘land’ in the context of factors of production.
Natural resources and inputs available in a country.
What can increase the quantity of labour in an economy?
Immigration or increased domestic birth rates.
How can the quality of labour be improved?
Through education and training, enhancing the human capital of a country.
What factors can increase the quantity of labour available in a country?
Immigration and domestic birth rates
These factors lead to more people of working age entering the labour force.
What is meant by the term ‘human capital’?
The quality of labour, improved through education and training
Economists refer to the skills and education of the workforce as human capital.
What happens to the Long-Run Aggregate Supply (LRAS) curve when the quality of labour rises?
It shifts rightward (outward)
This shift indicates an increase in the productive capacity of the economy.
What is the vertical section of the Keynesian Aggregate Supply curve indicative of?
Full employment
This section represents the maximum output of an economy where all resources are utilized.
What does capital refer to in economic production?
Tools and machinery used in production
This includes factories, roads, railways, and other infrastructure.
How can the quantity of capital be improved?
By investing in means of production, such as building more factories
Increased investment enhances the overall productive capacity.
What is required to improve the quality of capital?
Changes in the productivity of capital
This could involve retrofitting factories for energy efficiency or building faster railways.
What role do technological improvements play in economic production?
They allow for greater output with the same or fewer inputs
Technological advancements enhance productivity and economic possibilities.
What are some examples of improvements in efficiency?
Better-trained labour and more efficient production methods
These improvements can lead to long-term changes in the LRAS.
What can lead to changes in institutions affecting LRAS?
Factors such as private vs. public ownership, competition, government regulations, and bureaucracy
Institutional changes can influence market signals and growth capacity.
How has globalisation impacted production capabilities?
It has provided more opportunities for firms to access the global market
This expansion enhances the production capabilities of nations.
What determines equilibrium in the short run?
The intersection of aggregate demand and short-run aggregate supply.
What is the result of short-run equilibrium in terms of real output and price level?
Real output at Y and an average price level of P.
What occurs when aggregate demand decreases?
The economy produces below its full employment level, resulting in a recessionary or deflationary gap.
What is an inflationary gap?
A situation where real GDP is more than potential GDP, causing inflationary pressure.
What is stagflation?
A situation characterized by falling GDP, rising unemployment, and increasing price levels.
What happens when short-run aggregate supply (SRAS) shifts leftwards?
The economy produces less real GDP, and the price level increases.
What does a rightward shift in SRAS indicate?
An expansion of real GDP and a fall in price level.
How does aggregate demand affect the business cycle?
It creates shifts in output associated with the phases of the business cycle.
What is the effect of an increase in aggregate demand on real output?
An increase in real output from Y1 to Y2 and an increase in average price level from P1 to P2.
What happens when aggregate demand falls?
Firms will reduce output and prices may need to fall to encourage consumer spending.
What are the components that can change aggregate demand?
- Consumption
- Investment
- Government spending
- Net exports
What can shift the short-run aggregate supply curve?
Factors such as fuel prices and resource prices.
What is the natural rate of unemployment?
The level of unemployment when the economy is at full employment equilibrium.
Fill in the blank: When using AD and AS to show the real GDP of an economy, use the variable ____ to label the x-axis.
Y
True or False: A leftward shift in the SRAS curve always leads to an increase in real GDP.
False
What does the new classical model suggest about the economy’s tendency?
The economy will always tend towards full employment due to fully flexible prices.
What happens to output during a recession according to the new classical model?
Output falls from Yfe to Y1 and possibly the price level falls from P1 to P2.
What is a recessionary or deflationary gap?
It is the downward phase of the business cycle caused by falling aggregate demand.
How do firms respond to falling demand during a recession?
Firms may cut costs by terminating workers or reducing wages.
What occurs to aggregate supply as wages are cut during a recession?
Aggregate supply increases from SRAS1 to SRAS2.
What does the new classical perspective say about government intervention during a recession?
The economy self-corrects, supporting a laissez-faire approach.
What is the impact of increased aggregate demand on prices and wages?
There is upward pressure on the price level and wages.
What is an inflationary gap?
It is the situation where aggregate demand increases, leading to upward pressure on prices.
What happens to the labor market during economic growth according to the new classical model?
Demand for labor rises, leading to stronger bargaining power for workers.
What does the new classical model emphasize about the long run?
The economy returns to the full employment level of output in the long run.
What does the full employment level of output correspond to?
It corresponds to the natural rate of unemployment.
What was the Keynesian response to the Great Depression?
Advocated increased government spending to correct the economy.
What assumption does Keynes challenge regarding resource prices?
He challenged the assumption that resource prices will fall in a deflationary environment.
What is a deflationary gap according to Keynes?
It is a situation where the economy achieves equilibrium below the full employment level.
What does Keynes argue about economies during a recession?
They can get ‘stuck’ below the full employment level without government intervention.
What does reaching the full employment level of output signify?
It signifies reaching the economic potential of the economy.
How does competition for workers affect wages and prices in the labor market?
Firms must offer higher wages, leading to an increase in the average price level.
According to Keynes, what happens to real GDP and price level during a recession?
Both decrease with the leftward shift of aggregate demand.
Fill in the blank: The Keynesian theory developed as a response to the inability of economies suffering during the Great Depression to correct themselves according to the _______.
[new classical theory]
True or False: According to the new classical model, short-run fluctuations in output will significantly affect real GDP.
False
What does the production possibility curve illustrate?
It illustrates the economic potential determined by the quality and quantity of production factors.
What does the term ‘natural rate of unemployment’ refer to?
It refers to the rate of unemployment at full employment output.
What is the view of new classical economists on market disequilibrium?
Disequilibrium is corrected by market forces
According to Keynesians, how should unemployment be treated?
Should not be allowed to persist as long-term unemployment reduces economic potential
What do new classical economists believe about trade unions and minimum wages?
They will reduce the ability of the labour market to establish equilibrium
How do Keynesians view wages?
Wages are downward inflexible or ‘sticky’
What is the role of government according to new classical economists?
Should support markets to be able to return to equilibrium
What do Keynesians believe about government intervention during a recession?
Government must intervene with government spending
What is the new classical view on government borrowing?
Government borrowing crowds out private investment
True or False: Keynesians believe there is no crowding out during recessions.
True
What factors affect the flexibility of prices according to the text?
Type of goods, severity and length of economic contraction, regulations
What was the inflation status in the UK during the global financial crisis of 2008 according to the consumer price index?
Did not register any deflation
In contrast to the UK consumer price index, what did the retail price index show during the same period?
Showed deflation of more than 1%
What is a potential outcome of a lasting economic contraction in some countries?
Deflation is likely
What do new classical economists advocate regarding government intervention?
Less government intervention in markets
What is the aim of ‘supply-side’ policy?
Increase aggregate supply by expanding business investment and production
What do Keynesians argue is more important than long-term growth?
Focusing on the present and intervening in markets
What term did Keynes coin to describe the feelings of people and businesses in an economy?
‘Animal spirits’
What happens when ‘animal spirits’ are low according to Keynes?
The economy can get ‘stuck’ in a recession
What do Keynesians implement at the first sign of economic slowdown?
Expansionary policies
What is the paradox of thrift as described by Keynes?
During recessions, governments should borrow and spend to boost the economy
What is the new classical view on deficit spending?
Government borrowing crowds out private investors
What happens to the supply of loanable funds when the government sells bonds to finance deficit spending?
It reduces the supply and raises interest rates
