Aggregate Demand and Supply

Question 1

What are the two weaknesses of the AE model?

Answer 1

The Aggregate Expenditure model only shows the impact of a change in spending on output. It says nothing about the impact of changing expenditure on the general price level (inflation).

Another weakness is that it only focuses on the demand side of the economy- it ignores the supply side.

Question 2

What important economic variables are not incorporated into our model of the business cycle?

Answer 2

The effect of changes in important economic variables such as labour force, capital stock, the level of technology, and production costs are not incorporated into our model of the business cycle.

Question 3

What are the three key economic variables that the AD/AS model enables us to analyse?

Answer 3

The three key economic variables that the AD/AS model enables us to analyse are:

• Economic growth
• Unemployment
• Inflation

Question 4

Define aggregate demand.

Answer 4

Aggregate demand is the total amount of spending in the economy.

Question 5

What relationship does the AD curve show?

Answer 5

The AD curve shows the relationship between the price level and the quantity of real GDP demanded by each of the different sectors: households (C), firms (I), government (G), and overseas (NX).

Question 6

Describe the slope of the AD curve.

Answer 6

The AD curve slopes downwards and describes a negative relationship between the level of aggregate demand and the price level.

Question 7

Identify the three reasons why the AD curve has a negative slope.

Answer 7

1 The income or wealth effect.
2 The interest rate effect.
3 The open economy effect.

Question 8

Explain the income or wealth effect.

Answer 8

A rise in the price level (inflation) reduces the purchasing power of household income or wealth. As the price level increases, the purchasing power of your income falls and consumption decreases.

Question 9

Explain the interest rate effect.

Answer 9

Inflation effects interest rates. A rise int he general price level means that households and firms will demand more funds to finance their transactions. They could do this by withdrawing money from banks, by borrowing or by selling financial assets such as bonds.
The rising demand for money drives interest rates upwards, increasing the cost of borrowing, which is a disincentive to spend.
This is called the interest rate effect- a rise in the price level increases interest rates, which has a negative impact on investment and consumption spending.

Question 10

Explain the open economy effect.

Answer 10

The aggregate demand curve slopes downward as a result of the ‘international’ or ‘open economy’ effect.
If the domestic price level (inflation) rises relative to other countries, domestic goods and services become less competitive in those countries, leading to a decrease in exports.
At the same time, a rise in the domestic price level will mean that consumers and businesses will purchase more goods and service from foreign producers and less from domestic producers. So spending on imports will increase and net exports (X-M) will fall.

Question 11

Summarise the impact of an increase/decrease in the general price level on total spending and how this is shown on an AD curve.

Answer 11

In summary, increases in the general price level (inflation) can be expected to reduce total spending in the economy and cause a movement up and to the left along the AD curve.
Falls in the price level can be expected to increase total spending in the economy and cause a movement down and to the right along the AD curve.

Question 12

What factors can bring about a shift of the AD curve?

Answer 12

The whole AD curve will shift to the left or the right if factors other than the price level were to change.
This means that any factor that changes consumption, investment, government spending, or net exports will bring about a shift of the entire aggregate demand curve.

Question 13

What could cause an increase in consumption and what would be the effect of this?

Answer 13

If consumption were to increase because the government decided to decrease income taxes, then the AD curve would shift tot eh right- this is referred to as an increase in AD. An increase in AD increases real GDP and employment.

Other factors that could cause an increase in consumption could be a rise in consumer confidence, a rise in share prices increasing household wealth or a fall in interest rates.

Question 14

What could cause investment spending to fall and what would be the effect of this?

Answer 14

If investment spending were to fall because of a decline in business confidence or a rise in interest rates, then the AD curve would shift to the left- this is referred to as a decrease in AD.
A decrease in AD will reduce real GDP and employment.

Question 15

What will be the effect of changes in government spending on the AD curve?

Answer 15

Changes in government spending will also shift the AD curve. An increase in G will shift the AD curve to the right, while a decrease in G will shift it to the left.

Question 16

Give an example of how changes in global economic growth will impact the AD curve and what the effect of this will be.

Answer 16

Changes in global economic growth will have an impact on Australia’s exports.
Higher economic growth in China will increase Australia’s exports and shift the AD curve to the right, increasing real GDP and employment.

Question 17

With the use of a diagram explain the impact of a higher inflation rate on GDP.

Answer 17

The aggregate demand curve shows the total amount of spending in the economy at each price level. A rise in the price level (higher inflation rate P1 -> P2) causes a movement upwards along the AD curve reducing aggregate spending and real GDP (Y1 -> Y2).

Question 18

With the use of a diagram explain the impact of a rise in consumer confidence on AD.

Answer 18

A rise in consumer confidence will increase household consumption causing an increase in AD- the AD curve will shift to the right, increasing real GDP.

Question 19

With the use of a diagram explain the impact of a fall in business confidence on AD.

Answer 19

A fall in business confidence or a rise in interest rates will decrease investment causing a decrease in AD- the AD curve will shift to the left decreasing real GDP.

Question 20

Define the aggregate supply curve.

Answer 20

The aggregate supply curve is the relationship between the total production of goods and services and the general price level.

Question 21

Why is the short run supply curve (intermediate range) positively sloped?

Answer 21

The short run aggregate supply curve is upward/positively sloped.
This curve shows the impact of an increase in total production (GDP) on the inflation rate. This means that as the level of economic activity increases, the price level rises.
This occurs because to increase production, firms require increased resources of labour and capital and this puts pressure on resources prices.
The most important cost of production is the price of labour- wages. As production increases, wages begin to rise and this causes the general price level to rise.
This is especially true as the economy approaches full capacity or full employment.

Question 22

Explain with the use of a diagram why an increase in GDP causes the price level to increase.

Answer 22

An increase in real GDP (Y1 -> Y2) will cause the price level to rise from P1 to P2 because production costs have increased.

Question 23

Why is the long run aggregate supply curve vertical?

Answer 23

The long run aggregate supply curve (classical range) is vertical because it represents the maximum level of output at a particular point in time. This means that the level of real GDP does not change as the price level changes.

Question 24

What determines the position of the LRAS curve?

Answer 24

The position of the LRAS curve is determined by the size of the economy’s work force, the quantity of capital and the state of technology.

Over time, the potential level of output increases because technology improves, and both the labour force and the capital stock increase.
This means that the vertical LRAS curve SHIFTS to the right over time- at about 3.25% per year.
This number comprises the growth in the labour force plus the growth in labour productivity.

Question 25

Draw an aggregate supply curve, labeling the three ranges.

Answer 25

Keynesian (horizontal) range, intermediate (ideal) range, classical (vertical) range.

Yp is potential income and is in line witht he classical range.

Question 26

Why is the Keynesian range of the AS curve flat/horizontal?

At what levels of GDP does it occur?

Answer 26

At low levels of real GDP, the economy has significant spare capacity. This means that there are unemployed labour and capital resources.
Increases in economic activity can increase real GDP with little or no effect on the price level. So, at low levels of real GDP, the AS curve is fairly flat or horizontal. This section of the AS curve is referred to as the Keynesian section of aggregate supply. Economic output can expand with little impact on inflation.

Question 27

Describe the intermediate range of the AS curve and the level of GDP at which it occurs.

Answer 27

As the economy approaches its full employment or natural rate of output, the AS curve starts to slope upwards. This is referred to as the ‘intermediate’ section of the AS curve.
Rises in real GDP cause the price level to increase because the labour and other input markets are beginning to tighten. Competition among producers for reduced supplies of resources will cause their prices to increase (for example, increased wages).

Question 28

Describe the classical range of the AS curve.

Answer 28

When the economy reaches the full employment level of output (Yp), the AS curve becomes vertical. This is referred to as the ‘classical’ range of AS. Increases in economic activity cannot increase real GDP- rather the price level rises and the economy experiences a sharp rise in inflation.

Question 29

What factors cause shifts in the SRAS curve?

Answer 29

Shifts in the AS curve are caused by factors that can affect the supply of resources and the costs of production across the entire economy.

Question 30

Give some examples of events that would cause a leftward shift if the AS curve.

Answer 30

Events that would cause a leftward shift if the AS curve:

• Increase in oil prices.
• Unproductive staff
• Increase in fuel and transport costs.
• Natural disaster to hit Australia

Question 31

Give some examples of events that would cause a rightward shift if the AS curve.

Answer 31

Events that would cause a rightward shift if the AS curve:

• Increase in the labour force
• Increase in productivity
• Improvement in the state of technology

Question 32

Explain what causes demand and output to fall to a level below equilibrium and what the effect of this is. Use a diagram.

Answer 32

When demand and output falls to a level below that of equilibrium (deficient level of AD), the whole AD line moves down and to the left (a decrease in total expenditure from AD1 to AD0).
This is caused by weaker demand-side conditions.
e.g. a recession overseas, higher disposable income.

Question 33

Describe with the use of a diagram the impact of weak aggregate demand-side conditions.

In what years did this occur in Australia?

Answer 33

If weak aggregate demand-side condition prevail of Australia (e.g. as in 2008-09) the total expenditure is only as AD0, the equilibrium level of economic activity (measured by real GDP) will also be down and GDP0. Low or falling production will cause rising cyclical unemployment and perhaps even a recession. Living standards would fall.

Question 34

Give the characteristics of a contractionary gap.

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Answer 34

• Lower rates of inflation due to spare capacity in the economy.
• Higher levels of cyclical unemployment because the demand for final goods and services has fallen.
• A fall in the labour force participation rate- many people believe they have less change of finding a job, so they withdraw from the workforce.
• A fall in company profits which reduces business confidence.
• Slower growth in consumer expenditure, and a reduction in sales of consumer durables.
• Falling share prices which has a negative effect on investment (share prices fall because of falling company profits- less attractive to invest).
• Increased government spending on welfare.
• Lower interest rates due to expansionary monetary policy.
• The current account deficit usually falls, (balance increases) if investment decreases relative to savings (the I-S gap decreases, less investment into Australia).

Question 35

When will a rightward shift in AD have more of an impact on price level? Use a diagram to explain.

Answer 35

A rightward shift in AD will have more impact on the price level if the economy is close to its capacity than if it had unemployed resources.

Question 36

What impact will strong aggregate demand-side conditions have on the economy? Include a diagram in your explanation.

Answer 36

At the opposite extreme, if strong aggregate demand-side conditions caused expenditure to rise excessively to AD2, the new equilibrium located high up on the AS line will cause economic activity to rise to GDP2.
While soaring production is often seen as good, the problem with this is inflation.
Because of excessive spending, production cannot keep up and the economy overheats. General shortages of goods and services develop, causing rising prices and demand inflation.
This is seen by the terrible hike in the price level to P2. Living standards would suffer.

Question 37

When will domestic economic stability occur?

Answer 37

Between the two extremes of deficient and excessive levels of AD, there is an ideal pace of domestic economic activity. If aggregate demand conditions cause expenditure to be at AD1, domestic economic stability or bliss should exist.
Equilibrium would occur with near maximum production and employment (at GDP1), but without the problem of rapid inflation in the general level of prices (prices at P1).
Here, our short-term material living standards should be maximised.

Question 38

Give the characteristics of an expansionary gap.

Answer 38

• Higher rates of inflation due to tightness in the labour market (not enough workers).
• Low levels of cyclical unemployment- consumer demand for goods and services is high and firms need to employ labour to produce those goods and services.
• A rise in the labour force participation rate, as people expect they will be successful in finding a job.
• An increase in company profits and business confidence.
• Increased consumer confidence and an increase in sales of consumer durables.
• Rising share prices.
• Decreased government spending on welfare.
• Higher interest rates due to contractionary monetary policy.
• The current account deficit usually rises if investment increases relative to savings (the I-S gap increases).

Question 39

Explain with the use of a diagram the impact of favourable supply side conditions.

Answer 39

Let us first assume that supply-side conditions changed favorable and producers were keener and more able to increase their production from AS1 to AS2.
Notice that there is a rise in the quantity supplied at all price levels and thus, the whole AS line shifts outwards.
The new equilibrium (E2) created as a result of an increase in AS, means a rise in national output and employment from GDP1 to GDP2.
This is beneficially combined with a general fall in the price level from P2 to P3. Here, the rise in AS means that there is improved domestic economic stability and material living standards.

Question 40

Explain, using a diagram, the impact of unfavourable supply side conditions (causing a shift to the left of the supply curve).

Answer 40

However, what if supply conditions became unfavourable and producers were less willing and able to make output available?
Supply would fall from AS1 to AS0 and real production and employment would decline from GDP1 to GDP0.
Furthermore, because a typical cause of less favourable supply-side conditions such as there is rising production costs or falling profits, firms may be forced to lift their prices and thus accelerating cost inflation from P1 to P0.
Here, supply-side conditions have caused an unfavourable economic situation called stagflation (simultaneous low GDP growth, high structural unemployment and rapid cost inflation).
The solution is to implement government policies to improve supply conditions.

Question 41

When will a contraction occur and what can cause it, in terms of changes in AD and AS.

Answer 41

A contraction occurs when the rate of economic growth decreases- the level of real GDP falls and unemployment (mainly cyclical) increases above the natural rate.
A contraction could be caused from either a decrease in the AD curve or a decrease in the short run AS curve. Both will reduce real GDP and the unemployment rate.

A business cycle contraction can result from a negative aggregate supply shock.

Question 42

What can cause a decrease in the short run AS curve?

Answer 42

A decrease in the short run AS curve could be caused by a steep and prolonged rise in world oil prices or a natural disaster such as severe drought.

Question 43

Give some examples and explain how supply shocks can effect the Australian economy.

Answer 43

The Australian economy is often subject to periods of drought which can have a significant effect on the rural economy.
Other examples include when oil prices increased significantly in 2011, increased from less the $1 per litre to around $1.50 per litre. Unanticipated increases in energy prices adversely affect production costs through virtually every industry in the economy.

Question 44

What will be the impact of a decrease in the short run AS curve?

Answer 44

A decrease in the short run AS curve not only increases unemployment (because real GDP has fallen) but also increases the price level.
The economy experiences cost inflation, which is the worst type of inflation because it is associated with a contracting economy.
The term ‘stagflation’ was coined to refer to a negative supply shock- a stagnant economy combined with inflation.

Question 45

Why is cost inflation a difficult policy issue for policy makers to deal with?

Answer 45

Cost inflation is a difficult policy issue for policy makers to deal with.
For example, the Reserve Bank cannot reverse a natural disaster or reduce world oil prices so that Australian motorists can have lower petrol prices.
In most cases, we have to ‘rise out’ a negative supply shock and wit for the economy to self-correct.

Question 46

What are the two main reasons for a business cycle expansion?
What will be the effect of this expansion?

Answer 46

The two main reasons are either an increase in aggregate demand that pushes the economy above potential GDP, or an increase in short run aggregate supply.
Both will lead to production and employment increasing, pushing umeployment below the natural rate.
An increase in AD may be caused by some event that increases investment spending and net exports, raiding national income.
An expansion (e.g. mining boom) caused by shifts of the AD curve to the right is associated with higher rates of demand inflation.
An expansion that is caused by the short tun AS curve shifting to the right will cause inflation to fall. This could occur in the event of the application of new technologies which boost labour productivity.

Question 47

Why does potential GDP increase at a consistent rate over time?
How is this represented?

Answer 47

Potential GDP increases at a consistent rate over time as the labour force grows (due to natural increase and migration). The stock of capital equipment rises and the level of technology improves.
Growth in potential GDP would be represented on the AD/AS model as a rightward shift of the LRAS curve over time.
When actual GDP is above potential GDP, the economy is experiencing an expansion.
When actual GDP is below potential, the economy is experiencing a contraction.