3.2 Variations in Economic Activity (AD + AS)

Question 1

Define aggregate demand:

Answer 1

“Total demand for goods and services in an economy from households, firms, government and foreigners at different price levels over a period of time.”

Question 2

What are the 4 components of AD?

Answer 2

• Consumption
• Investment
• Government consumption
• (Exports - Imports)

Question 3

What’s the calculation for AD?

Answer 3

AD = consumption + investment + government consumption + (exports - imports)

Question 4

What are the three reasons why an AD curve to slope downward?

Answer 4

• Wealth effect
• Interest rate effect
• Net balance effect

Question 5

What is the wealth effect?

Answer 5

As the average price level falls, the wealth of participants in the economy increases in real terms as their ability to purchase goods and services improves. The real value of assets, like property or stock, is now higher.

Question 6

What is the interest rate effect?

Answer 6

At lower price levels, interest rates are lower too, giving people more disposable income to spend and with which to demand higher volumes of output. The incentive to save is also lower.

Question 7

What is the net balance effect?

Answer 7

A lower price level makes goods and services relatively cheaper for foreign countries to buy. Therefore, the demand for exports rises and the demand for imports from abroad falls, increasing the net trade balance and leaving it in an overall better position.

Question 8

What are the factors causing a shift in AD?

Answer 8

• Changes in Consumer spending
• Changes in Investment spending
• Changes in Government spending
• Changes in Foreigners spending

(For exact examples check evernote)

Question 9

Define aggregate supply:

Answer 9

“The total output that all firms in a country are able to produce at any given price level.”

Question 10

What happens in the short run (SR) in macroeconomics?

Answer 10

When the cost of production, particularly labor cost, does NOT change.

Question 11

What causes the cost of production to remain the same in the short run?

Answer 11

due to strict Labor Laws, minimum wage, trade unions and labor contracts protecting the wages in the short run.

Question 12

Why is AS upward sloping?

Answer 12

Prices increases in the economy, and costs don’t change in the SR, the producers, as profit maximisers can earn more profit by increasing their supply. So when price increases, there is an increase in Aggregate Supply. This is why AS is upward sloping.

Question 13

What are the factors causing a shift in AS?

Answer 13

• Change in cost of production (Land, Labour, Capital, Raw materials..etc)
• -> Increase in cost of production = Inward shift of AS (left shift)
• Change in technology
• -> improvement of technology leads to more efficient production = Outwards shift of AS (Right shift)
• Change in indirect taxes
• -> Higher indirect taxes, cost of production increases = Inward shift of AS (left shift)
• Change in subsidies
• -> Government gives producers a subsidy, decreases cost of production = Outward shift of AS (right shift)
• Any supply shock
• -> Weather conditions, war, natural disasters… etc (eg. covid 19) Can be positive + OR negative -

Question 14

What is the “NRU”?

Answer 14

Natural Rate of Unemployment

Question 15

If an economy produces optimally, can still be unemployment?

Answer 15

Yes. When an economy produces optimally it still has unemployment - which is called “Natural rate of unemployment”. Unemployment of 0% is impossible, as some people choose not to be employed, there can be a skills miss-match or seasonal factors.

Question 16

If the prices increase, what happens in the long run?

Answer 16

If the prices increase, that means the cost of living will also increase, resulting in an increase in wages. This means the cost of production has increased and therefore the Aggregate supply will shift to the left (AS1 to AS2).

Question 17

What does the new classical school assume?

Answer 17

The new classical school assumes that if prices are fully flexible in the long run, the price level does not affect the level of output of firms and their profits, so firms have no incentive to produce more in the long run. If the price level of goods and services falls, and firms can lower wages of workers, then firms can employ the same number of workers and produce the same output.

Question 18

What does this diagram show?

Answer 18

A deflationary gap is a situation where real GDP is less than potential GDP due to insufficient aggregate demand

Question 19

What does this diagram show?

Answer 19

An inflationary gap is a situation where real GDP is greater than potential GDP due to excess aggregate demand.

Question 20

What does this diagram show?

Answer 20

When the economy is running at full employment equilibrium level of GDP the AD curve intersects the SRAS curve at the level of potential GDP.

Question 21

What does this diagram show and explain the movement

Answer 21

In the deflationary gap diagram, the economy is initially in the long run equilibrium at point A. However a fall in Aggregate Demand from AD1 to AD2 causes a short run movement of the economy from point a to point b. At point b there is a “deflationary gap” as the real GDP is less than the potential GDP due to insufficient Aggregate Demand. At point b the price levels has also dropped to P2. The economy can not remain at point B in the long run. In the long run the fall in price level is matched by a fall in wages (and falls in resource prices) so the SRAS curve shifts from SRAS1 to SRAS2 until the economy is back on the LRAS curve. (point C). At point C the real GDP = the potential GDP so the deflationary gap that was apparent at point B has been eliminated.

Question 22

What does this diagram show and explain the movement

Answer 22

In the inflationary gap diagram, the economy is initially in the long run equilibrium at point A. However an increase in Aggregate Demand from AD1 to AD2 causes a short run movement of the economy from point A to B. At point A there is an “inflationary gap” as real GDP is greater than potential GDP. At point B the price levels have increase to P2. In the long run this increase in price is matched by an increase in wages (and resources) increasing the cost of production causing an inward shift of the SRAS curve, from SRAS1 to SRAS2, causing a movement of the economy from point b to c, which is back on the LRAS curve, where the real GDP = the potential GDP so the inflationary gap that was apparent at point B has been eliminated.

Question 23

What are the factors causing a shift in LRAS?

Answer 23

Increases in quantities of factors of production

–> Increase in quantity of FOPs means that the economy is able to produce more output

Improvements in the quality of factors of production

–> The greater the quality of FOPs means more output can be produced

Improvements in technology

–> Improved technology means that the FOPs using it can produce more output

Increases in efficiency

–> When an economy increases its efficiency in production, it makes better use of scarce resources

Institutional changes

Reductions in the Natural Rate of Unemployment (NRU)

–> The lower the NRU (less people employed) the more output the economy can produce

Question 24

What did Keynes believe in?

Answer 24

Keynes claimed that in deep recessions, when situation keeps getting worse, wages become sticky downward (people are so pessimistic that people will reject wage cuts)

If the wages refuse to fall, then the producers can not keep decreasing their prices (which is why there is a plateau)

Question 25

What is the main difference between New Classical and Keynesian models?

Answer 25

In the new classical model inflationary and deflationary gaps are automatically corrected as long as resources prices, especially wages, are free to change as the price level changes. So according to the New classical model government should try to make the markets work as freely as possible.

By contrast, one of the most important ideas arising from the Keynesian interpretation of the AD-AS model is that deflationary/ recessionary gaps can persist over long periods of time. According to Keynes, this happens partly because of the inability of wages and prices to fall. He believed people acted rationally and would not keep accepting wage cuts. According to the Keynesian model, the government must intervene in the economy with specific measures to help it come out of the deflationary gap.

Question 26

What happens in section 1 on this keynesian diagram?

Answer 26

The real GDP is low, and the price level remains constant as real GDP increases.

In this range of real GDP, there is a lot of unemployment of resources and spare capacity. (spare capacity refers to the availability of resources including physical capital

Question 27

What happens in section 2 on this keynesian diagram?

Answer 27

Increases in real GDP are accompanied by increases in price level. This is because as the output increases, so does the employment of resources and bottlenecks will start to appear as there is no longer spare capacity in the economy.

Question 28

What happens in section 3 on this keynesian diagram?

Answer 28

The AS curve becomes vertical, which indicates that real GDP reaches a level beyond which it can not increase any more. Real GDP cannot increase any further becomes firms are using the maximum possible amount of labour and resources in the economy. Any efforts by firms to increase the output will result in a greater increase in price.

Question 29

What does the Keynesian model believe about “wages”?

Answer 29

Wages are sticky downwards, at some point people will act rationally and not accept the wage cut.

–> They don’t fall in deep recessions, so the economy can get stuck in recession over a long period of time

Question 30

What is the difference in “government intervention” between New Classical and Keynesian models?

Answer 30

New Classical model believes the government is not needed to operate at Yfe. And lets the market operate and restore by themselves,

Keynesian model believes that in deep recession, the government should spend through Budget deficit. They take on loans and aggressively invest in it’s economy. Like this they shift AD outwards.