AD & AS (C & I) (Topic 11)

Question 1

Why will output change by more than the change in AD

Answer 1

There is a multiplier effect. The multiplier tells us the number of times output changes whenever AD changes

Multiplier = Change in output / change in AD

Question 2

Why is there a multiplier effect?

Answer 2

Because an initial change in spending will cause further rounds of spending

Keynesian economies assumes that people can only be consumed (spent) or saved

Y = C + S

Question 3

4 equations

Answer 3

1) Change in consumption when you get additional income

MPC = ∆C / ∆Y

2) Change in saving when you receive additional income

MPS = ∆S / ∆Y

3) Multiplier = 1 / MPS

4) ∆ Y = 1 / MPS x ∆AD

Question 4

Determinants of consumption (C)

Answer 4

1) Expectations
Consumers expectations of the future

Expect inflation, buy now and save less (AD shift to right)

Expect recession, buy later and save now (AD shift to left)

2) **Wealth*
An increase in financial wealth leads to a rise in consumption expenditures (vise vera)

3) Interest rate
More durable goods (like cars) are purchased with borrowed funds.

A lower rate of interest on loans encourages consumers to borrow more and consume more.

A higher interest rate discourages borrowing, so they consume less

Question 5

What is investment expenditures

Answer 5

Expenditures by firms for new capital goods

Question 6

Determinants of investment

Answer 6

1) Expectations
Firms’ expectations concerning the economy can affect investment

Expect an expansion in the economy, increase investment (AD shift right)

Expect a downturn, decrease investment (AD shift left)

2) Technological change
Technological progress gives rise to the introduction of new products and the need to replace obsolete capital equipment

New technologies crease investment spending, invent increase

3) Interest rate
Capital goods are usually bought with borrowed money.

An increase in the interest rate leads to an increase in the cost of borrowing, firms will borrow lesser lesser causing investment to fall (vise versa)

3) Government policies
An increase in business taxes would lower profitability and decrease investment

Government may wish to encourage investment by allowing a tax credit for new investment, investment will increase

4) Depreciation
Depreciation is the wearing out of existing capital equipment.

The larger amount of capital equipment and the older that stock, the larger is the amount of capital that wears out, more investment is needed to replace that worn-out capital