9: Aggregate demand and aggregate supply

Question 1

Definine aggregate demand:

Answer 1

Aggregate demand is total amount of real GDP that consumers, firms, the government and foreigners want to buy at each price level (not just consumers).

Question 2

What does the AD curve show?

Answer 2

The relationship between the real GDP and the economies price level, ceteris paribus.

Question 3

Why does the AD curve have a negative slope?

Show a diagram:

Answer 3

1. The wealth effect
2. The interest rate effect
3. The international trade effect

Diagram:
Price level on y, real GDP on x.
Downward sloping curve labelled AD.

Question 4

Explain the wealth effect:

Answer 4

Changes in the price level affect the real value of people’s wealth. If the PL increases people feel worse off and cut back on their spending.

Question 5

What is the difference between wealth and income?

Answer 5

Income is a salary where as wealth is the value of things that you own. A person with a low income but an expensive house has a lot of wealth for example.

Question 6

Explain the interest rate effect:

Answer 6

Changes in the PL affect rates of interest, which in turn affect aggregate demand. An increase in the PL leads to consumers and firms needing more money. As demand for money increases so does interest rates. More people save and less borrow.

Question 7

Explain the international trade effect:

Answer 7

If the domestic price level increases whilst price levels in other countries remain the same, exports become more expensive for foreign buyers who will now demand a smaller quantity of these. Imports for domestic buyers are cheaper so they switch to these meaning there is less output.

Question 8

How is aggregate demand different from microeconomic demand?

Answer 8

demand in microeconomic reflects the willingness and ability of consumers to buy a single product at different price levels where as aggregate demand reflects the willingness and ability of all buyers (consumers, government, businesses and foreigners) to buy the economy’s aggregate output or total real GDP at different price levels, over a time period.

Question 9

What causes a shift in aggregate demand?

Answer 9

A change in any of the four components that make up aggregate demand: consumer expenditure, government expenditure, investment expenditure and net exports.

Question 10

What factors lead to changes in consumption spending:

Answer 10

1. Changes in consumer confidence. This is how confident consumers are about the future state of the economy and their incomes.
2. Change in interest rates. A higher interest rate means more saving and less borrowing.
3. Changes in wealth. An increase in stock market values or homes for example means wealth is increased. This shifts the AD curve to the right.
4. Changes in personal income taxes. This effects disposable income. An increase in taxes leads to less disposable income, thus less spending and AD shifts to the left.
5. Changes in level of household indebtedness.
   If people have a lot of debt then they are likely to cut back on spending.

Question 11

What factors lead to changes in investment spending?

Answer 11

1. Changes in business confidence. If businesses are optimistic about their sales they will spend more on investment, shifting AD to the right.
2. Changes in interest rates. A lower interest rate decreases the cost of borrowing so firms borrow more and invest more, shifting the curve to the right,
3. Improvements in technology. Improvements in technology stimulate investment spending which increases AD, shifting it to the right.
4. Changes in business taxes.
5. The level of corporate indebtedness.
6. Legal changes. A law may arise that means small businesses do not have access to credit, so they cannot borrow easily to finance investments. This decreases AD, shifting it to the left. Securing rights would shift it to the right.

Question 12

What factors lead to changes in government spending?

Answer 12

1. Changes in political priorities. For example a government may decide to increase spending to improve healthcare as they believe it will help them get reelected.
2. Changes in economic priorities, deliberate efforts to increase aggregate demand

Question 13

What factors lead to changes in net exports?

Answer 13

1. Changes in national income abroad. If the economy of france increases, it will import more from surrounding countries, such as the UK, thus shifting the UK’s AD to the right.
2. Changes in exchange rates. If the price of the pound increases, it will cost more for France to import British alcohol. This means it imports less, and the UK’s exports fall, decreasing aggregate demand. In addition, France’s exports are now cheaper for the UK so imports increase. Net exports, X - M, falls as X is smaller and M is larger. The AD curve shifts to the left.
3. Changes in levels of trade protection. For example to US implemented tariffs on steel from abroad, causing imports to fall and increasing net exports as well as increasing domestic consumption, shifting the AD curve to the right.

Question 14

How do changes in wealth cause a shift and a movement along the AD curve?

Answer 14

When the price level increases, causing wealth to increase, this leads to a movement along the AD curve. For example a house increasing in value. However, when a non price related even causes an increase in wealth, such as inheritance, this is a shift in the AD curve.

Question 15

What is the short run in macroeconomics?

What is the long run in macroeconomics?

Answer 15

A time period in which the prices of resources are roughly constant and inflexible.

The long run in macroeconomics is a time period in which the price of all resources, including the price of labour (wages) are flexible and change along with changes in the price level.

Question 16

Why are wages often unchanging?

Answer 16

1. Labour contracts fix wage rates for certain periods of time.
2. Minimum wage requirements fixes the lowest legally permissible wage.
3. Workers and labour unions resist wage cuts.
4. Wage cuts have negative effects on worker morale, so firms tend to avoid them.

Question 17

Define aggregate supply:

Answer 17

The total quantity of goods and services produced in an economy (real GDP) over a particular period of time at different price levels.

Question 18

What is the short run aggregate supply curve?

Answer 18

The SRAS curve shows the relationship between price level and quantity of real GDP produced by firms when resource prices, particularly wages, do not change.

Question 19

Explain, using a diagram, why the SRAS curve is upwards sloping?

Answer 19

An increase in price level means that output prices (basically not cost of production) has increased as the economy is in the short run so resource prices do not change, meaning firm’s profit increases.

Question 20

What factors cause a shift in the SRAS curve?

Answer 20

1. Changes in wages. If for example a new legislation decreases the minimum wage, and the price of the good remains the same, firms cost of production decreases and the LRAS shifts to the right.
2. Changes in non labour resource prices. If the price of non-labour resources such as the price of oil, equipment, capital goods and so on change, they will cause a shift in the SRAS.
3. Changes in subsidies offered to businesses. If they increase they shift the SRAS to the right and visa versa.
4. Supply shocks - events that have a sudden and strong impact on the SRAS such as earthquakes or violent conflict leading to destruction of physical capital causing a leftwards shift of the SRAS. They could also be sudden changes in the firms cost of production, such as a massive decrease in the price of oil.

Question 21

Explain the determination of the short run equilibrium using a diagram.

Answer 21

PL on y, Read GDP on x.
Show AD and SRAS. where they intersect right Ple and Ye. Then draw two other Pl lines, one above and one below. Explain that at the one above there is an excess supply of real GDP and the Pl falls until it reaches Ple and visa versa.

Question 22

Show and explain why a deflationary gap happens using a diagram.

Answer 22

PL on y, Read GDP on x.
Show AD and SRAS. where they intersect right Ple and Ye.
Draw a vertical line to the right of the intersection and where it meets the x axis put Yp. This represents potential GDP.
Explain that here real GDP is less than potential GDP meaning the economy is experiencing a deflationary gap and unemployment is greater than the natural rate of unemployment.
This occur because at the price level Ple, the amount of real GDP that the four components of AD want to buy is less than the economy’s potential GDP. There is not enough total demand in the economy to make it worthwhile for firms to produce potential GDP. Less labour is required for production so unemployment is greater than the natural rate.

Question 23

Show and explain why an inflationary gap happens using a diagram:

Answer 23

PL on y, Read GDP on x.
Show AD and SRAS. where they intersect right Ple and Ye.
Draw a vertical line to the left of the intersection and where it meets the x axis label it Yp for potential GDP.
Explain that potential real GDP is greater than potential GDP and the unemployment rate is lower than the natural rate of unemployment. An inflationary gap arises because there is too much demand in the economy and firms respond by producing a greater quantity of real GDP than potential GDP, meaning they require more labour and unemployment becomes less than the natural rate.

Question 24

Show when the economy is at full employment level of output using a diagram:

Answer 24

PL on y, Read GDP on x.
Show AD and SRAS. where they intersect right Ple and Ye.
A vertical line down that intersects with the intersection, label it Yp.

Question 25

Describe how shifts in the AD curve correlate to inflationary/deflationary gaps?

Answer 25

At full employment shift left of the AD curve means that Yp is now to the right of the AD curve, meaning there is deflationary gap (potential output is greater than real GDP). A shift of the AD curve to the right means the Yp curve is now on the left, which is an inflationary gap.

Question 26

Describe how shifts in the AS curve correlate to inflationary/deflationary gaps?

Answer 26

If the AS curve shifts left, PL increases but real GDP decreases meaning there is more unemployment, which is particularly undesirable. This is called stagflation. In the 1970s it happened frequently due to increases in oil prices.

Question 27

What is the neoclassical approach to the LRAS?

Answer 27

From a neoclassical perspective the LRAS curve is vertical at the full employment level indicating that in the long run the economy produces potential GDP, independent of the price level.

Question 28

Why is the LRAS curve vertical according to neo-classicists?

Answer 28

The LRAS curve is vertical at the full employment rate because wages are now changing to match output prices so firms costs of production remain constant even as the price level changes. For example if the price level changes wages will also change by the same amount. Thus, a firms profits are constant and they no longer have incentive to increase or decrease their output levels.

Question 29

Explain, using a diagram, why in the neoclassical approach is the LRAS situated at the level of potential GDP?

Answer 29

Pl on y, Real GDP on x.
Show SRAS, AD and LRAS in the cross.
Show a leftward shift in AD to AD2. Show the new price level (Pl2) and the new Y level (Y rec).

However due to wage and price flexibility the economy cannot remain there in the long run. The fall in the Pl is matched by a decrease in wages, so SRAS moves down to the right, creating a new Pl3. AD2 and SRAS2 intersect along the LRAS curve so output is still as Yp, although the price level has dropped.

Question 30

Thus, from a neoclassical perspective what does a change in the LRAS equilibrium mean? Explain the impacts of this using a diagram:

Answer 30

A change in the LRAS equilibrium means that there is only a change in the price level as the equilibrium level of GDP remains unchanged at potential output (Yp).
Diagram:
Two intersections: SRAS1 and AD1 showing P1, SRAS2 and AD2 showing P2. Both intersecting on separate points on the vertical line LRAS, at Yp.

Question 31

Why do firms get stuck in the short run?

Answer 31

Keynsian economists argue that there is an asymmetry between wage changes in the upward and down directions. In an inflationary gap with unemployment lower than natural rate and a rising price level, wages can quickly move upward. In a deflationary gap however wages are reluctant to move downwards due to labour contracts, minimum wage legislation and resistance to wage cuts. In addition, product prices do not fall easily as in a recession if wages do not go down firms will avoid lowering their prices as it will reduce their profits. Furthermore oligopolistic firms do not want to bring prices down as it may lead to price wars which make both firms worse off.

Question 32

Do Keynesian economists believe that wages will never fall?

Answer 32

No, if the recession continues long enough and becomes a depression wages will eventually fall. But it could take years and this is bad for the economy considering it would leave to unemployment and loss of output in this time.

Question 33

What does the Keynesian aggregate supply curve look like?

Answer 33

It has three sections.
In the first section GDP is very low. There is a lot of unemployment of resources and spare capacity. Firms can easily increase their output by employing the unemployed capital without having to bid up wages and resource prices. In section II, real GDP increases are accompanied by increases in the price level. This is because eventually there is no spare capacity in the economy meaning costs of production increases. In order to increase their output firms must sell at higher prices, since they must hire more labour and pay more wages etc. It reaches Yp (potential GDP) in section II around where it starts to increase. Employment can fall further however so real GDP continues to increase. The supply curve becomes vertical as GDP cannot increase any more. This is the Ymax level. Any attempts from firms to increase output only leads to increases in price level but not output.

Question 34

What are the three equilibrium states of the economy with in the Keynesian model?

Answer 34

The AD can intersect the Keynesian AS before Yp (deflationary gap), after Yp (inflationary gap), or at Yp (full employment equilibrium).

Question 35

Why do Keynesian economists believe that recessionary gaps can persist for long periods of time?

Answer 35

Partly because of the inability of wages and prices to fall as well as insufficient aggragate demand.

Question 36

Is keynesian analysis short run or long run?

Answer 36

Short run. This does not mean Keynesian economists do not consider what happens over long periods of time, but rather that they do not accept the idea that the economy can move into what neoclassicists define as the long run.

Question 37

Discuss, using diagrams, the differences in the Keynesian and neoclassicist models in terms of the outcome of increases aggregate demand.

Answer 37

Show two diagrams, one is the neoclassic model where LRAS is a vertical line at Yp (potential GDP). Show three different AD curves intercepting with it.

Show the Keynesian AS curve, horizontal then vertical. show three AD curves. The AD curve can shift to the right but because it is horizontal this can lead to an increase in real GDP without affecting price level. When it comes close to full employment an increase in AD may increase the Pl too.

Question 38

Can the LRAS or Keynesian AS curve shift? What does this signify?

Answer 38

Yes, if the potential GDP changes. An increase in potential output signifies economic growth over the long term.

Question 39

What factors shift AS curves over the long term?

Answer 39

1. Increases in quantities of the factors of production, for example the discovery of new oil reserves in Saudi Arabia will shift their AS to the right.
2. Improvements in the quality of factors of production. For example better healthcare leads to a more productive workforce.
3. Improvements in technology. Machinery that can decrease production time, such as sewing machines, can shift the AS curve to the right.
4. Increases in efficiency. When an economy can make better use of its scarce resources it can produce a greater quantity of output.
5. Institutional changes. The degree of public and private ownership for example, such as in the UK the postal service is becoming privatised which may decrease or increase potential output, depending on economies of scale.
6. Reductions in the natural rate of unemployment. If it decreases the country can make better use of its resources and therefore output increases.

Question 40

How does a shift of the AS curves look?

Answer 40

Neoclassical:
The vertical line shifts right or left.

Keynesian:
The vertical part of the line shifts right or left making the horizontal part longer or shorter.

Question 41

What is the relationship between LRAS and SRAS curves in the neo classical model?

Answer 41

Any factor that moves the LRAS indicates long term economic growth, meaning the SRAS will likely eventually move with it. In addition, the AD curve will move as many of the factors that cause AS to move are the same as LRAS. For example, increase in the quantity of physical capital will result in a positive change in both AS and AD.

There are events that can move the SRAS and not the LRAS, such as seasonal changes in weather that effect the quantity of output in certain areas such as agriculture. When weather patterns return however, the SRAS will shift back.

Question 42

Why does a change in expenditure produce a larger change in total aggregate demand and real GDP?

Answer 42

The initial change in expenditure leads to a chain reaction of further expenditures, this is called induced spending. Say for there is an initial increase of investment spending of 8 million. This increases the GDP by 8 million but it does not end there as this 8 million is also used by businesses to pay for materials, equipment, labour, etc. and all this spending translated into income for the owners of the factors of production who then use it to increase their consumption spending. This increases GDP further than the original 8 million.

Question 43

How does the Keynesian multiplier depend on leakages?

Answer 43

The Keynesian multiplier is the change in the real GDP divided by the initial change in expenditure. This is affected by marginal propensity to consume which is the fractional of additional income that households spend on consumption of domestically produced goods and services. The higher this fraction, the more money is induced, and the larger the multiplier.

Question 44

How do we calculate the Keynesian multiplier? What is this equivalent to?

What conclusion can you draw from this?

Answer 44

1/(1-MPC) this is equivalent to 1/MPS + MPT + MPM

Therefore the larger to MPC, the larger the multiplier. More money flows back into the economy. Alternatively, the smaller the leakages, the greater the multiplier.

Question 45

What corresponds to MPC? What can you say about these things?

Answer 45

Marginal propensity to save (MPS)
Marginal propensity to tax (MPT)
Marginal propensity to import (MPM)

MPC + MPS + MPT + MPM = 1

Question 46

What is autonomous spending?

Answer 46

Spending that has not been caused by a change in income.

Question 47

How can the multiplier effect be initiated?

Answer 47

The multiplier effect can only be initiated by a change in autonomous income.

Question 48

Explain the effect of the multiplier in relation to price level:

Answer 48

The full effect of the multiplier can only be experiences when the price level is constant. If the PL is increasing, the greater the PL increase the smaller the size of the multiplier effect. This is because it is a Keynesian model and you have the horizontal and vertical things. You can show it on the model.