A2 Aggregate Demand and Supply

Question 1

What does the aggregate supply curve show?

Answer 1

How much output firms would be willing to supply at any given price level (could be short run or long run).

Question 2

What does the aggregate demand curve show?

Answer 2

The main components of aggregate demand are consumer spending, government expenditure, firm investments and net exports. The curve shows the relationship between these factors combined (AD) and the price level.
It shows planned spending at any given price level

Question 3

What is the national income multiplier?

Answer 3

The idea that an increase in one of the components of aggregate demand (autonomous spending) will result in a multiplied increase in national output.

Question 4

How is the multiplier calculated?

Answer 4

1/ Marginal Propensity to Withdraw

Question 5

What can reduce the size of the multiplier?

Answer 5

When the additional money in the circular flow is not being spent instead it leaks from the system through saving, imports and tax (marginal propensity to….)

Question 6

What is the effect of a multiplier on the AD curve?

Answer 6

The AD shifts further to the right than what it would if there was no multiplier.

Question 7

How is the short-run aggregate supply curve different to the long run.

Answer 7

In the short run, often output can’t be increased once the economy reaches full capacity. This is because factors such as capital are difficult to increase in the short-term although labour can be increased in the short -term

Question 8

How is the aggregate demand curve different to a demand curve for an individual product?

Answer 8

The AD curve shows the relationship between the total goods and services in an economy and the overall price level.

Question 9

How did approaches to macroeconomic policy change during the Great depression?

Answer 9

People started to doubt the neoclassical view of the economy that focused on microeconomics and instead started to look at the economy in the aggregate.

Question 10

How did approaches to macroeconomic policy change through Keyne’s influence?

Answer 10

He focused on the aggregate demand and discovered how the government could influence the level of AD and the macroeconomic equilibrium.

Question 11

How did approaches to macroeconomic policy change under the monetarist (new classical) school (through-out the 70s)?

Answer 11

They believed the economy would always go back to an equilibrim level of output that they called the natural rate of output, they believed the adjustment to this rate would happen very quickly.

Question 12

What is the natural rate of unemployment?

Answer 12

The equilibrium level of full employment as according to monetarists.

Question 13

Why is the long run aggregate supply curve vertical according to monetarists?

Answer 13

Since the economy always adjusts back to the equilibrium level of full employment output is not affected by a change in price level (aggregate supply is perfectly inelastic).

Question 14

Why did the Keynesian school believe that the economy would settle at a level below full employment?

Answer 14

They believed the macroeconomy wasn’t flexible enough to maintain full employment. Due to inflexibilities in the labour market e.g. geographical immobility employment wouldn’t be able to adjust to full.

Question 15

Give an idea that proves the monetarist theory of a vertical demand curve wrong

Answer 15

Such a demand curve would mean that any increase of AD would only increase the price level, it wouldn’t affect the output level. This is not true as we know government expenditure has caused inflation.

Question 16

What is short-run economic growth?

Answer 16

An increase in actual GDP as the economy moves towards full capacity (shift in AD)

Question 17

What is long-run economic growth?

Answer 17

An increase in the productive capacity of the economy This is because the total resources available to people in a country increase as time goes by.

Question 18

Why is economic growth seen as the most important macroeconomic policy objective

Answer 18

Economic growth allows an economy to improve its standard of living as it increases the resources available to people.

Question 19

What determines the position of the LRAS curve?

Answer 19

A shift in this curve can arise from an increase in the factors of production e.g mass migration increasing the size of the workforce (e,g. A8 accession in 2004)
Or an increase in the efficiency as to which the factors are utilised (improvements in productivity)

Question 20

Why is it important that economic growth is sustainable?

Answer 20

Economic growth must be sustainable as it is the quality of resources that are available that determines standard of living not just quantity. Also of importance is that they are divided up appropriately among society, there is no point in achieving this growth if it makes those of future generations worse off.

Question 21

Does an increase in AD result in inflation?

Answer 21

An increase in aggregate demand results in a higher price level, it only results in persistent inflation if AD keeps shifting.

Question 22

What are the three ultimate objectives for macroeconomic policy?

Answer 22

Economic growth
Economic stability
International competitiveness

Question 23

What is the Phillips curve?

Answer 23

A curve that suggests that a low level of unemployment will mean there is a high level of inflation.

Question 24

Why did Phillips believe that low unemployment meant that inflation would be high?

Answer 24

He believed that high demand for labour would result when unemployment was low as workers were scarce, this increases the wage bargaining power of workers increasing the amount of wage that firms pay their workers. This would result in the firm passing on the increased costs due to the higher wage to consumers in the form of higher prices.

Question 25

Why is it likely that there will be a trade off between unemployment and inflation policies?

Answer 25

If the Philips curve is correct policies that try to reduce inflation are likely to result in in increased unemployment. !below graph pg 235!

Question 26

What is stagflation?

Answer 26

A situation in an economy where there is high unemployment and high inflation at the same time.

Question 27

Evaluate the relationship between unemployment and inflation that is suggested by the Phillips curve

Answer 27

Stagflation can result in high inflation and unemployment as opposed to the inverse relationship suggested by the Phillips curve.
-employers may not pass on the profit made from lower staff costs to consumers via the price

Question 28

What is a counter-argument to stagflation as an evaluation point of the Phillips curve

Answer 28

A shift of the Phillips curve can show stagflation or the opposite.
After an initial change in price, people may bargain their wages based on what their expectations for inflation are.
If there is expected to be high inflation if workers bid their wages up in real terms they’ll expect a proportionately higher salary.
This increases costs faced by firms and unemployment returns to the natural rate as the firm demands less labour.

Question 29

What is full employment?

Answer 29

It is when there is no demand-deficient (cyclical unemployment) (this is when there is not enough aggregate demand in the economy so there is less demand for labour as there is not enough demand for the firms product (derived demand).Any unemployment occurs from the supply, not the demand side of the market (only structural, seasonal , frictional).

Question 30

Why may the Phillips curve be vertical in the long-run

Answer 30

As according to the adaptive expectations theory once inflation has hit the NAIRU and is embedded in the economy people will make expectations that inflation will remain at this level and henceforth bid up their wages in real terms according to this inflation rate. Firms will respond to the changes in the wage rate by changing supply (AS) and the economy will be in equilibrium and return to the natural rate of unemployment. Henceforth, it is only in the short run that the Phillips curve will be downward sloping and show a trade -off between unemployment and inflation as in the long run it will be vertical as no matter what the inflation level the economy will return to the natural rate of unemployment.

Question 31

Why may the Phillips curve be vertical in the long-run

Answer 31

As according to the adaptive expectations theory once a change in the price level occurs people will make expectations about inflation based on what it has been in the past. Workers will then negotiate their wages in real terms according to this inflation rate. Firms will respond to the changes in the wage rate by changing supply (AS) and the economy will be in equilibrium and return to the natural rate of unemployment. Henceforth, it is only in the short run that the Phillips curve will be downward sloping and show a trade -off between unemployment and inflation as in the long run it will be vertical as no matter what the inflation level the economy will return to the natural rate of unemployment.

Question 32

Evaluate the adaptive expectations theory.

Answer 32

Monetarists believe that instead of workers taking decisions based on past performance of the economy instead they would use all the information available to them as well as past performance.

Question 33

What is the NAIRU?

Answer 33

Non- accelerating inflation rate of unemployment is the rate of unemployment in an economy that is consistent with a constant rate of inflation (the natural rate of unemployment).

Question 34

why can the natural rate of unemployment can be referred to as the non-accelerating inflation rate of unemployment

Answer 34

As according to monetarists unemployment will always return to the natural rate and once it settles into equilibrium since it always returns to this unemployment level the inflation rate will remain constant.

Question 35

What is the economic cycle?

Answer 35

Where GDP fluctuates around a long run average (underlying trend) following a regular pattern of fluctuation.

Question 36

What is the output gap?

Answer 36

The difference between an economy’s actual GDP and its potential (trend level)

Question 37

What is a recession?

Answer 37

When the economy’s real GDP falls over 2 consecutive quarters (not reduced economic growth e.g. Q1:0.9 Q2:0.7 Q3:0.5, negative economic growth e.g. Q1:0.9 Q2:-0.1 Q3:-0.5

Question 38

What is long run economic growth?

Answer 38

When there is an increase in the potential rate of growth of GDP essentially an increase in the productive capacity of the economy (Long run aggregate supply)

Question 39

What is short-run economic growth?

Answer 39

An increase in real GDP

Question 40

What is the difference between the actual and trend rate of growth?

Answer 40

The actual rate of growth is the rate of GDP growth while the trend rate is how much economists believe the economy could grow without causing inflationary pressure.
On the other hand trend rate growth is the sustainable long run average rate of growth

Question 41

What are the diagrams that you could use to show the output gap?

Answer 41

AD/AS Diagram-the output gap is shown by the difference between the natural rate of output and the equilibrium level.
Production Possibility Curve- The economy has a negative output gap if it is producing anywhere inside of the curve.

Question 42

What are the stages of economic growth?

Answer 42

• Boom
• Slow-down
• Recession
• Recovery

Question 43

What is the boom of the economic cycle?

Answer 43

This is found when actual growth is above the trend rate of growth (positive output gap) up until the peak, inflation is most likely at this point

Question 44

What is an economic slow-down?

Answer 44

Once the peak has been passed real GDP begins to fall, yet the output gap is still positive

Question 45

What is a recession in the economic cycle?

Answer 45

Actual GDP has been falling for two consecutive quarters until it hits a trough.

Question 46

What is the recovery stage of the economic cycle?

Answer 46

When actual (real GDP) starts to grow again but GDP is still below its trend value (negative output gap)

Question 47

What is national income?

Answer 47

This is the monetary value of the flow of goods and services produced in an economy over a period of time (GDP).

Question 48

What is national income the same as?

Answer 48

National income=National Output= National Expenditure (Aggregate Demand)

Question 49

What is the national income multiplier?

Answer 49

Any increase in autonomous spending will result in a multiplied increase in national income.

Question 50

What determines the size of the multiplier?

Answer 50

The multiplier only occurs if the initial money that is spent leads to further spending. If the additional income is not spent the multiplier is diluted, the marginal propensity to withdraw shows how much withdrawals reduce the multiplier.

Question 51

What is the marginal propensity to withdrawal made up of?

Answer 51

Marginal Propensity to Tax
                              to Save (interest rate level can impact)
                              to import

Question 52

What is the marginal propensity to tax

Answer 52

This is the proportion of extra income that is taken back to the government in taxes.

Question 53

The multiplier can be calculated by the following 1/MPW, what is the other way to calculate the multiplier?

Answer 53

1/ 1-Marginal Propensity to Consume

Question 54

What is the marginal propensity to consume?

Answer 54

The proportion of additional income that is spent on consumption

Question 55

What is induced consumption?

Answer 55

Spending that varies with income level.

Question 56

What is the accelerator?

Answer 56

It is the idea that a changes in investment can be linked to changes in real output (GDP).

Question 57

Why is an increase in GDP linked to an increase in investment?

Answer 57

Most investment is done when firms want to expand their capacity (produce more). If there is an increase in demand for a firms product (or an expected increase) it may expand capacity to meet the demand. Therefore, as consumer expenditure increases (and so does GDP) investment increases.

Question 58

What is the multiplier-accelerator model?

Answer 58

That the multiplier and accelerator effect enforce each other.
If there is an increase in spending and as according to the multiplier this could result in an increase in consumers demand for the firms products (depending on MPW) which may result in the firm needing to expand capacity and spend on investment to do so.

Question 59

What is investment?

Answer 59

Spending on capital such as factories and machinery.

Question 60

How is it possible that an economy can produce past its level of full employment?

Answer 60

Full employment means there are still unemployed people on the demand side of the economy e.g. (frictional, structural) so perhaps firms have employed some of these people.
Full employment in the long term means that workers are operating at a sustainable level but in the short term perhaps they are working unhealthily long hours to produce past the natural rate of output.