Aggregate Demand And Supply

Question 1

Definition of aggregate demand

Answer 1

The total demand for final goods and services in an economy at a given price level over a given period of time

Question 2

Aggregate demand curve

Answer 2

Shows the amounts of goods and services that will be purchased over a given period of time at all possible price levels
When the average price level rises there is a fall in the level of real GDP and when the average price level falls there is a rise in the level of Real GDP (inverse relationship)

Question 3

Interest rate effect (demand side)

Answer 3

Higher prices lead to higher interest rates to compensate for the effect of inflation which in turn means higher nominal interest rates tend to reduce consumption and investment.

Question 4

Wealth effect (demand side)

Answer 4

Higher prices lead to a reduction in the purchasing power of household wealth. A loss of real wealth leads to less consumption.

Question 5

International competitiveness effect (demand side)

Answer 5

Higher domestic prices (assuming no change in price level overseas) make exports less competitive and imports more attractive. Therefore the loss of competitiveness reduces the value of net exports

Question 6

Movement along AD curve

Answer 6

When price level falls from 150 to 100 for example, AD expands from 650b to 1000b

Question 7

Shift in AD curve

Answer 7

When a non-price level factor causes a change in the level of one or more of the components of aggregate demand (C+I+G+X-M) the AD curve will shift.

Question 8

Factors that can shift AD

Answer 8

Consumption: Income, Real interest rates, Wealth, Consumer confidence or expectations
Planned Investment: Real interest rates, Profitability, New Technology, Business Confidence
Government Spending: Political Philosophy, Performance of Economy, Demand Management
Net Exports: Cyclical Factors (growth here and overseas), Structural Factors (affecting international competitiveness), Shocks (drought & floods)

Question 9

Definition of Aggregate Supply

Answer 9

Aggregate supply is the total value of goods and services produced in an economy at a given price level over a given period of time.

Question 10

Aggregate Supply Curve

Answer 10

Three different curves:
- New classical short run AS curve
Short run is defined as the time period in which prices of factors production do not change and it is dependant on the price level
- New Classical long run AS curve
Long run is defined as the time period from 3 years + and therefore the price level has no effect on the long run curve
- Keynesian AS curve

Question 11

Movement along the SRAS Curve

Answer 11

A movement along the SRAS occurs when the price level increases meaning firms have a greater incentive to produce

Question 12

Shift in the SRAS curve

Answer 12

The SRAS curve will shift its position up and to the left if there is a rise in production costs. If it shifts down and to the right then there is a fall in production cost and more goods and services will be produced

Question 13

Factors affecting a shift in the SRAS curve

Answer 13

Changes in wages
Changes in productivity
Changes in raw material prices (oil, iron ore)
Changes in import prices due to a change in the exchange rate

Question 14

When will the LRAS curve shift its position

Answer 14

• Shifts to the right when the capacity or level of potential GDP of the economy increases. Eg. Discovery of more resources, investment in capital equipment incorporating new technology, a rise in productivity or improved economic situations
• Shifts to the left when the capacity or level of potential GDP of the economy decreases. Eg. Natural disasters, depreciation of capital equipment, outwards migration or a fall in productivity

Question 15

Keynesian Aggregate Supply Curve

Answer 15

Three stages of the Keynesian Supply Curve:

• Keynesian stage: AS is perfectly elastic and there is a low level of capacity utilisation and high unemployment. Firm can meet demand for extra output and increase profits without raising prices because the cost of resources has not changed
• Intermediate stage: GDP is greater than Y1 but below the level of income that creates full employment, resources become increasingly scarce and prices start to rise as a result. Producers will raise prices to increase profits
• Classical stage: Economy reaches the income level that creates full employment, output gap cannot be increased further. Firms can’t push production beyond capacity or the level of potential output. Firms will need to raise prices to stay profitable.

Question 16

Shifts in position of the Keynesian AS curve

Answer 16

• Will shift downward when there is a fall in the cost of production
• Will shift to the right when there is an increase in production capacity
• Will shift downward and to the right and when there is a fall in costs and an increase in the production capacity

Question 17

Short Run Equilibrium in the new classical model

Answer 17

SR equilibrium will occur when AD equals SRAS. It’s only a short run equilibrium position because the recessionary gap between Y1 (current equilibrium) is less than YFE which is the LRAS so there is a surplus in resource markets and the cost of resources will fall shifting the SRE again.

Question 18

Long Run Equilibrium in the new classical model

Answer 18

LR Equilibrium will occur when AD crosses with SRAS and also LRAS. At this full employment occurs and potential output = actual output

Question 19

Government’s policy response

Answer 19

New classical Response to recessionary or deflationary gap is to wait for self adjustment
Keynesian Response to recessionary or deflationary gap is to intervene with extra government spending or lower taxes otherwise wages and other resource prices become ‘sticky’ through no self adjustment.

Question 20

Equilibrium using the Keynesian model

Answer 20

Equilibrium occurs when AD = AS. Because of the curve, equilibriums may occur at different levels of GDP.

Question 21

AD shocks

Answer 21

A rise in autonomous spending, a rise in planned investment, an increase in government spending or a rise in net exports.
- this cause a rise in real GDP (economic growth) that in turn leads to a fall in unemployment and a rise in the price level (inflation).

Question 22

Business Cycle

Answer 22

Slump: AD is low and output gap is large. Level of real GDP is low and so is the price level
Recovery: AD increase and output gap is reduced. Real GDP grows and price level increases
Boom: AD is high and output gap is small. Real GDP is high and so is the price level.
Downturn: AD decrease and output gap increases. Real GDP and PL fall
(All diagrams are done on Keynesian model.)

Question 23

AS shocks

Answer 23

A fall in the cost of production, an increase in the capacity or potential output of the economy.