4.2.2.2_-_Aggregate_demand_and_aggregate_supply_analysis

Question 1

What is aggregate demand (AD)?

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 does price relate to aggregate demand?

Answer 2

Changes in the price level cause movements along the aggregate demand curve.

Question 3

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

Answer 3

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 4

What changes shift the AD curve?

Answer 4

The AD curve is shifted by changes in the components of AD (C, I, G or X-M)

Question 5

How is the net export aspect of AD affected by currency value changes?

Answer 5

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

Question 6

What is the wealth effect?

Answer 6

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

Question 7

What is Aggregate Supply (AS)?

Answer 7

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

Question 8

Why is the AS curve upwards sloping?

Answer 8

The AS curve is upward sloping because at a higher price level, producers are willing to supply more because they can earn more profits.

Question 9

What causes movements along the AS curve?

Answer 9

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, from Y1 to Y2. If AD falls, there is a contraction in SRAS, from Y1 to Y3.

Question 10

When does a shift in SRAS occur?

Answer 10

The SRAS curve shifts when there are changes in the costs of production

• Government regulation or intervention
• The cost of other inputs e.g. raw materials
• The cost of employment might change

Question 11

What is business regulation also known as?

Answer 11

red tape

Question 12

What does the SRAS curve show?

Answer 12

SRAS 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.

Question 13

Why is the SRAS curve upward sloping?

Answer 13

The curve is upward sloping because supply is assumed to be responsive to a change in AD, which is reflected in the price level.

Question 14

What does the LRAS curve show?

Answer 14

The long run aggregate supply curve (LRAS) 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. Similarly to the PPF, it can show the economy’s productive potential.

Question 15

Why is the LRAS curve vertical?

Answer 15

The curve is vertical, because supply is assumed not to change as the price level changes

Question 16

How does the LRAS curve show economic growth?

Answer 16

A rightward shift in the LRAS curve shows economic growth

Question 17

When does the economy reach the state of equilibrium?

Answer 17

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 18

How is excess supply and demand represented on a AD/AS diagram?

Answer 18

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 19

What does a shift in aggregate supply represent?

Answer 19

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 (PE to P1) and increases national output (YE to Y1).

If AS shifts inwards, price increases and national output decreases.

Question 20

What does a shift in aggregate demand represent?

Answer 20

If firms have less confidence or there is a recession, AD might shift inwards. This causes the price level to fall from PE to P1, and national output to fall from YE to Y1

If AD increases, the price level and level of national output both increase.

Question 21

What is demand-pull inflation?

Answer 21

When the aggregate demand in an economy strongly outweighs the aggregate supply, prices go up. This is the most common cause of inflation.

In Keynesian economic theory, an increase in employment leads to an increase in aggregate demand for consumer goods.

Question 22

What is the effect of a demand-side or supply-side shock on the macroeconomy?

Answer 22

An economy may start to shrink or grow
Demand-side shocks cause demand to rise or fall
Supply-side shocks causes supply to rise or fall

Question 23

What is an example of a demand-side shock?

Answer 23

Consumer confidence being boasted e.g. due to house prices rising, this will increase consumer spending

Question 24

What is an example of a supply side shock?

Answer 24

A poor harvest reduces the supply of food, increases its price, and reduces the economy capacity

Question 25

What is a demand-side shock?

Answer 25

A sudden unexpected event that dramatically increases or decreases demand for a product or service, usually temporarily.

Question 26

What is a supply-side shock?

Answer 26

A sudden event that causes an unexpected increase in costs or disruption to production. This will cause the short-run aggregate supply to shift

Question 27

When does a shift in LRAS occur?

Answer 27

Changes in the factors of production cause the LRAS curve to shift (Quality or Quantity)

LRAS is determined by the factors of production - the LRAS curve will shift if there is a change in the factors of production which affects the capacity of the economy

Question 28

How do banks play a part in determining the position of the LRAS curve?

Answer 28

Firms often borrow money from banks for investment, if a country has a strong banking system this will help its economy to grow as there is more money available for investment within the economy and this should lead to an increase in the productive potential an economy has. So improvements in a country’s banking system will shift the LRAS and the SRAS curve to the right