Aggregate Demand And Supply

Question 1

What does aggregate mean

Answer 1

Added together, the individual elements that were introduced in microeconomics are totalled in macroeconomics.

Question 2

Aggregate demand (AD) and aggregate supply (AS) analysis brings what together?

Answer 2

Brings together the amount that consumers wish to consume and firms wish to produce at any price level.

Question 3

The equilibrium point where AD meets AS determines…

Answer 3

The average price level and the equilibrium real output level. The price level can be measured by a price index such as the CPI and the output by the real GDP.

Question 4

Define aggregate demand

Answer 4

Aggregate demand (AD) is the total planned expenditure on goods and services produced in an economy over a period of time.

Question 5

Define aggregate supply

Answer 5

Aggregate supply (AS) is the total planned output of goods and services in an economy over a period of time.

Question 6

What does aggregate demand comprise of

Answer 6

Aggregate demand comprises of consumption (C), investment(I), government expenditure (G), and exports (X) minus imports (M)

Question 7

What’s the formula for AD

Answer 7

AD = C + I + G + (X - M)

When the price level falls, the level of AD expands along the AD curve; when price level rises, the AD contracts.

Question 8

What’s a common misunderstanding to do with why the AD curve is downwards sloping

Answer 8

The curve Is downwards sloping but NOT because people buy more when they are cheaper.

Question 9

Tell me a reason why the AD curve is downwards sloping to do with lower prices and competitiveness

Answer 9

Lower prices in an economy mean increases international competitiveness, so there are more exports and fewer imports. In other words, net exports are higher at lower prices.

Question 10

Tell me a way to explain why the AD curve is downwards sloping to do with the real balance effect

Answer 10

Total expenditure by the economy remains much the same along the AD curve. For example, when there is a fall in the price level, people still spend approximately the same amount but they buy a larger amount of goods and services. This is called the real balance effect.

Question 11

Tell me a way to explain the downward sloping AD curve to do with higher price levels

Answer 11

At higher price levels, interest rates are likely to be raised by the monetary authorities. This means that investment - a component of AD - falls and savings might increase.

Question 12

What is the main component of AD

Answer 12

Consumption, approximately 60%

Question 13

What is consumption

Answer 13

Consumption is equal to spending by households on goods and services, it comprises approximately 60% of AD.

It measures the amount that consumers wish to spend at various price levels. If you ignore tax and spending on imports, a persons income is either spent (C) or saved (S). The higher the income after tax (disposable income), the more people are likely to spend, but they might spend at a slower rate as they earn more I.e - people tend to save a higher proportion of their income as their income rises.

Question 14

What are the key factors that affect consumption (spend rather than save)

Answer 14

Amount of disposable income

Consumer confidence

Interest rates

The housing market

Question 15

What’s a determinant of consumption to do with disposable income

Answer 15

The higher the income after tax (disposable income), the more people are likely to spend, but they might spend at a slower rate as they earn more - I.e people tend to save a higher proportion of their income as income rises.

Question 16

Tell me about a determinant of consumption to do with confidence

Answer 16

The more people feel they need to save, the less they spend, or vice versa. One of the key determinants of consumption is confidence of the consumer. Confidence is influenced by factors such as job security and future income prospects. If consumers are feeling confident, they are more likely to make large purchases that they can pay for in the future.

Question 17

Tell me about the determinant of consumption: interest rates

Answer 17

Higher interest rates not only leave consumers with less spending money after mortgage payments on house purchases, but they also increase the cost of borrowing.

Question 18

Tell me how the housing market is a determinant of consumption

Answer 18

When house prices accelerate upwards, home owners can extract more equity from their houses. (Wealth effect will later be discussed dw 🐷)

Question 19

There is generally a positive correlation between the growth in consumer spending and

Answer 19

The growth in real output

Question 20

Tell me about investment as a component of AD

Answer 20

Investment is an increase in the capital stock. It means creating assets that will generate income in the future rather than in the immediate term. Investment firms around 10-15% of AD, but the figure depends on whether you are considering gross or net investment.

Question 21

What is gross investment

Answer 21

Gross investment is the total amount of investment before any account is taken of depreciation of assets. Capital loses value as it wears out or becomes less efficient. Many machines become totally redundant as new methods of production are invented and the investment in these machines does not have any long term benefit on the economy.

Question 22

What is net investment

Answer 22

It takes account of the fall in value of capital assets. It is more significant for changes in the productivity of an economy and its productive potential.

Question 23

List the factors that influence the amount of investment

Answer 23

Interest rates

Profits of businesses

Taxation

Government policy

Exchange rate

Access to credit

New technology

Business confidence

Question 24

How are interest rates a factor that influences investment

Answer 24

An inverse relationship between interest rates and the level of investment would be expected. This is because increases in the capital stock have to be financed and there is an opportunity cost to that finance. Firms often borrow from banks to finance investment, so if interest rates rise, the cost of borrowing rises and firms are less likely to borrow and therefore less likely to invest. The prospects for future interest rates may be more significant than the current rate of interest and many firms watch closely the decisions on interest rates made by the Monetary Policy Committee. However, some argue that the interest elasticity of demand for investment is very low because other factors are much more significant.

Question 25

Tell me how profits of businesses is a factor that influences investment

Answer 25

Many businesses finance their investment from retained profits, i.e profits made in the past which have not been distributed to shareholders. If businesses have little retained profit then investment may be limited.

Question 26

Tell me how taxation is a factor that influences investment

Answer 26

Linked with profits of businesses, is the corporation tax rate (tax of company profits). If this is high, then this might limit the funds which companies have available for investment. In 2018, corporation tax rates ranged from 8.5% in Switzerland to 30% in OECD countries. The Uks rate was 19% for the tax year 2019 - 2020.

Question 27

Tell me how government policy is a factor that influences investment

Answer 27

If the government is following a reflationary economic policy, for example by increasing government expenditure and cutting taxes, then consumer spending will be rising and this could stimulate investment.

Question 28

Tell me how the exchange rate is a factor that influences investment

Answer 28

A low exchange rate would make a country’s exports more competitive and so lead to an increase in demand for them. This could encourage firms to increase investment because the prospect of making profits will have increased.

Question 29

Tell me how access to credit is a factor that influences investment

Answer 29

How keen banks are to lend and what conditions they apply to loans may have a significant impact on the ability of firms to invest.

Question 30

Tell me how new technology is a factor that influences investment

Answer 30

If there are new technological developments which could increase productivity and reduce unit costs, then firms in that market will have a great incentive to invest.

Question 31

Tell me how business confidence is a factor that influences investment

Answer 31

Investors are driven by factors that are likely to determine future sales. Anything that improves confidence in future sales patterns is likely to lead to a rise in investment. The indicators of this are changes in the rate of economic growth, business expectations, what their main competitors are doing, and government incentives and regulations.

Question 32

How can decisions on investment be explained by a kind of irrational behaviour of humans keen to make profit or avoid losses

Answer 32

It was described by Keynes as animal spirits.

Keynes believed that it was not rational thinking that made people invest or sell in capital and stocks markets. Instead, there is an animal or herd instinct. A rational person would sell when prices are high and make a profit. However, Keynes stated that our irrational instincts mean we buy when we see prices are rising. We sell when prices fall because, in a state of panic, we want to avoid further losses. This behaviour explains the enormous volatility in asset priced and means that investment of all kinds tends to exaggerate trends in the business cycle. This causes bubbles (which, by their nature, burst) and means that governments would do well to intervene to try to stop the extremities that occur when markets are left to their own devices.

Question 33

When was Keynes an influential commentator on economic issues

Answer 33

Throughout and between the world wars, and in particular through the Wall Street Crash of 1929 and the Great Depression that followed. His ideas provide an opposing view to the classical school, where humans behaviour is deemed to be rational, markets are best left to themselves (laissez faire) and governments have no discretionary or determining role in the level of AD.

Question 34

Define animal spirits

Answer 34

The forces that make markets move in large booms and busts, as people buy and sell impulsively rather than calmly, using purely rational behaviour.

Question 35

What circular relationship can be analysed using the accelerator to do with investment

Answer 35

A change in investment changes the level of AD, but a change in AD also changes the level of investment. This circular relationship can be analysed using the accelerator and, although this is not required knowledge for the exam, and it is a useful way of evaluating the role of investment.

Question 36

How important is government expenditure (G) in the UK and AD

Answer 36

Government expenditure in the UK comprises over 40% of all spending in the economy, totalling about £590 billion. However, as a component of AD it accounts for only around 25% because a large part of government expenditure is paid out as transfer payments, which are really a movement of spending power from taxpayers to other consumers (so features as consumption)

Question 37

What’s the main influence on government spending

Answer 37

The trade cycle. In a boom or period of high economic growth, government expenditure is likely to fall as there is less demand for social benefits to low income groups. Revenue from taxation is likely to rise too, so the government is expected to be able to run a budget (or fiscal) surplus during a boom.

Question 38

What’s the budget

Answer 38

Government spending does not need to equal tax revenue and the difference between them is known as a budget or (fiscal) deficit or surplus. The government can deliberately manipulate AD by overspending (running a budget deficit) when there is a slowdown in the economy, and vice versa in a boom. This discretionary fiscal policy is seen by many Keynesians as a way to prevent AD from collapsing in a recession.

Question 39

What may fiscal policy be used for

Answer 39

Discretionary fiscal policy is seen by many Keynesians as a way to prevent AD from collapsing in a recession. Fiscal policy may also be used to prevent bubbles in growth and markets from getting too big. Taxing more heavily in times of abundance is a useful way to put the brakes on the economy. Similarly, government spending can be increased and/or taxes cut in a recession. However, sometimes governments miscalculate the start of a downturn and cut taxes too early.

Question 40

How can the debt influence government expenditure

Answer 40

The national debt can affect G, which is the total amount of the governments outstanding debt. Governments hope that the budget will balance over the course of the economic cycle for current spending at least (not investment), otherwise the government will accrue national debt. Interest payments have to be made on this and if the government continues to overspend there will be a cost for future generations.

Question 41

What’s the Keynesian view on fiscal policy

Answer 41

The Keynesian view is that fiscal policy is a powerful tool in shifting AD, made much more effective by the working of the multiplier.

In contrast, the Classical economists view is that overspending by the government has a similar effect to printing more money - it is purely inflationary.

Question 42

What is the consensus on deliberate fiscal manipulation

Answer 42

There is some consensus that deliberate fiscal manipulation has a short run impact, but only if wage demands and other cost pressures are kept in check. Until the credit crunch and recession hit the economy in general in 2008, there was much consensus that it is only really through supply side policies that long term improvements in equilibrium employment will be achieved, as the AS curve shifts to the right. With the prospect of a repeat of the economic depression that followed the 1929 crash, Keynesian expansionary budgets again became popular. As Keynes would say, ‘in the long run we are all dead’: that is by the time the unemployed become employable, they will be past employment age, and sometimes the government must not sit by and let the economy go into a deep slump, but instead stimulate the circular flow through fiscal policy.

Question 43

A loose or expansionary fiscal policy means

Answer 43

Government spending is greater than taxation. This might mean an increase in government spending or a reduction in taxation, or that government spending is rising more quickly than taxation.

Question 44

Define fiscal policy

Answer 44

The deliberate manipulation of government spending and taxation in order to influence the level of AD in the economy.

Question 45

Tell me about Net trade (X -M) as a component of AD

Answer 45

Exports represent an injection into the circular flow of income, in that the money paid for goods and services abroad enters the domestic flow of income. Imports mean that there is an outflow of money. Exports minus imports gives the total movement of funds, known as net exports. (If the value of imports is greater than the value of exports, this will be a negative figure, as in the UK). There are several reasons why the value of net exports might change.

Question 46

Tell factors that may influence Net trade (X - M)

Answer 46

Changes in real income

Changes in the exchange rate

Changes in the global economy

The degree of protectionism

Non-price factors

Question 47

Tell me how changes in real incomes influences net trade (X-M)

Answer 47

This is an important factor influencing net exports. For example, if real incomes are rising more rapidly in the UK than in other countries then there is likely to be an increase in consumer expenditure, some of which will be spent on imports. This would result in a deterioration in net exports.

Question 48

Tell me how changes in the exchange rate influences net trade (X-M)

Answer 48

If this increases in value against another currencies, imports become cheaper and exports more expensive on world markets. Over time, people respond to these relative price movements and the demand for exports falls and the demand for imports rises. A stronger currency worsen net exports, whereas a weaker currency improves the figure. However, in the short run the price elasticity of demand for exports and imports tends to be low. This may be because contracts have to be signed for specific deals in international trade or because the traded components are a small percentage of firms overall costs. For example, an Italian importer of BMW minis will agree a price in advance of delivery from the UK. If the pound gets stronger against the euro, the price of the cars remains as per contract. Price elasticity of demand may also be low because of a lack of available substitutes, as in the case of oil. Owing to the low price elasticity of demand for exports and imports, the initial impact of a change in the exchange rate may be the opposite of the one described above.

Question 49

Tell me how changes in the global economy influences net trade (X-M)

Answer 49

For example, if there is a recession in the USA but the UK does not suffer a slowdown, the USA will buy fewer exports from the uk and will attempt to export more. Similarly, if the rate of inflation is higher in the uk than it’s major competitors, net exports from the uk will worsen as uk goods become increasingly uncompetitive. A collapse in a stock market in another part of the world may also have direct effects on UK exports via wealth effects.

Question 50

Tell me how the degree of protectionism influences net trade (X-M)

Answer 50

For example, if the USA imposes tariffs on uk steel then there will be a fall in exports and the net exports will fall.

Question 51

Tell me how non price factors influences net trade (X-M)

Answer 51

Non price factors, such as quality and after-sales service, are major determinants of exports. Germany, for example, cannot compete effectively on price, but the value of its exports exceeds that of many other countries because of high quality and design of its manufactured goods.

Question 52

What happens to AD when imports fall

Answer 52

The curve shifts to the right, as when any of the components of AD rises.

A useful evaluation point, is wise to consider that the changes involved with AD shifting involves levels rather than rates. In the UK these components do not usually fall, but they may rise more slowly during an economic slowdown. This means that the AD curve will still shift to the right but by increasingly smaller amounts.

Question 53

What is aggregate supply

Answer 53

Aggregate supply (AS) is the amount that firms are willing to produce at various price levels. It is largely influenced by productivity, which in turn is influenced by factors such as the costs of production, the level of investment, the availability and efficiency of factors of production and supply side policies.

Question 54

When does a movement along the AS curve occur

Answer 54

There is a movement along the AS curve when the average price level changes. For example, if AD shifts to the right and the AS curve is relatively elastic, firms will be willing to produce more at the higher price level.

Question 55

When will the whole AS curve shift

Answer 55

The AS curve will shift if there is a change in the costs of production faced by all firms. This might be because there is a change in the cost of raw materials, wages exchange rates, indirect tax rates (short run) or changes in productive potential, for example because there are new fertilisers to make land more productive, workers are better educated, there is improved technology or there is investment in efficient capital assets (long run)

Question 56

What does SRAS stand for

Answer 56

Short-run aggregate supply

Question 57

What does the SRAS curve look like

Answer 57

Shows that in the short run, when price level rises, the level of AS expands along the SRAS curve, and when the price level falls, the level of SRAS contracts. It’s a straight line like the normal supply curve from theme 1.

Question 58

When do shifts in aggregate supply generally occur

Answer 58

They occur when factors change that affect most firms. In the short run these changes simply affect firms costs of production and not the amount that they are willing and able to produce.

Short run shifts are often called external shocks and causes SRAS to shift up or down rather than right or left (which indicates a change in capacity)

Question 59

Short run supply shifts are often called what?

Answer 59

External shocks

Question 60

List me causes of short run aggregate supply shifts

Answer 60

Changes in the cost of raw materials and energy

Changes in exchange rates

Changes in tax rates

These factors might relate specifically to the cost of workers (labour market) or the way in which firms compete (product market)

Question 61

Tell me how changes in costs of raw materials and energy may cause a shift in the SRAS curve

Answer 61

In a developed country like the UK, most raw materials are imported and, if global supply increases, or global demand falls, costs of production to uk firms will fall. In contrast, if there is a global increase in the price of oil then this causes the costs of production to increase in the UK because oil is major production cost to almost all UK firms.

Question 62

Tell me how changes in exchange rates may cause a shift in the SRAS curve

Answer 62

If the euro falls in value relative to the pound, many costs will fall in the uk, meaning the SRAS in the UK will increase (shift to the right)

Question 63

Tell me how changes in tax rates may cause a shift in the SRAS curve

Answer 63

If there is an increase in indirect taxes, there will be an increase in costs for almost all firms in the UK. A rise in employers national insurance contributions, for example, is likely to cause all prices to increase as firms try to pass on these extra costs to the consumer. An increase in taxes will, therefore, cause a decrease in SRAS, i.e push it upwards/leftwards. By contrast, a cut in the tax on petrol prices causes an increase in SRAS.

Question 64

What are the two views on the long run aggregate supply curve (LRAS)

Answer 64

There are two views of AS, the Classical view and the Keynesian view

Question 65

Tell me about the Classical view of LRAS

Answer 65

The Classical view is that in the long run an economy will operate at full capacity and there will be no unemployed resources in the economy, I.e the LRAS curve is vertical. If there are any unemployed resources, the prices of these factors will fall until the surplus disappears.

Question 66

Tell me about the Keynesian view of LRAS

Answer 66

The Keynesian view is that the equilibrium level of output can occur below the full employment level of output. According to this view, the AS curve has a backward bending L shape, with three distinct sections: spare capacity, bottlenecks and full capacity. The assumption behind this analysis is that an economy can be at equilibrium when it is not at full employment. In other words, demand deficiency may mean that unemployed resources such as labour will not find work if the economy is left to its own devices.

Question 67

Explain to me the shape of the Keynesian LRAS curve - looks like a backwards L

Answer 67

At the section to the left, where the line is horizontal, there is spare capacity. So the economy can output without any cost pressures. This is because there are unused resources such as factories not working at full capacity or unemployed labour. In this section of the curve, AD may shift to the right, eg through fiscal policy, and equilibrium real output would increase without causing an increase in the price level. The next section is where the line starts to go from horizontal towards vertical but is not vertical yet. It is known as the bottleneck section, where some constrictions in the supply chain cause cost and wage pressures to build up in some areas of the economy. This usually involves a shortage of a particular type of labour which would case a rise in wages. An example concerns the limited availability of construction workers associated with the High Speed (HS2) rail link. If AD expands in this section of the graph, then although the economy will still grow, there will be some inflation. This occurs because the construction companies will have to raise wages in order to attract enough workers with the appropriate skills from other occupations. Where the LRAS becomes vertical, towards the right of the diagram, there is full capacity in the economy. All resources, including labour, are fully employed. Therefore, if a firm wants to take on more workers it will have to entice them away from other jobs by offering higher wages. In this section if the diagram, if AD increases, although in the short run there may be some extra spending, the long term effect will be increased inflation and no increased output.

According to the Classical view, this last vertical section is the only part of the AS curve that occurs. The economy cannot be in equilibrium while there is unemployment. So, if unemployment does exist, it can only result from a short run failure of the market or from mismanagement by the government.

Question 68

Tell me the factors that influence the LRAS in the labour market (would cause a rightward shift)

Answer 68

Changes in relative productivity

Changes in education and skills

Demographic changes and migration

Health spending increases

Question 69

Tell me the factors that influence the LRAS in the product market

Answer 69

Technological advances

Changes in government regulation

Competition policy and reduction in barriers to international trade.

Question 70

In the labour market, tell me how the following factor influences the LRAS: changes in relative productivity

Answer 70

Productivity is output per unit of input and, if it increases relative to a country’s main trading partners, the productivity gap is said to be closing. For example, the gap is currently closing between the UK and France, so although the uk has lower productivity than France, it’s productivity is increasing over time. This means that the costs of production are becoming relatively less expensive in the uk compared to France. However, the gap is widening between the uk and the rest of its partners. An increase in productivity may cause a rightward shift in the LRAS.

Question 71

In the labour market, tell me how the following factor influences the LRAS: changes in education and training

Answer 71

Increased spending on education and training should mean that a country’s workforce can produce more output per worker. Education increases the value of potential output. However, not all education achieves this end. It is not clear that a BA in Madonna Studies or a BSc In surf science has a major impact on costs of production in the uk.

Question 72

In the labour market, tell me how the following factor influences the LRAS: demographic changes and migration

Answer 72

A decreasing birth rate and increasing life expectancy in the UK will have a long lasting impact on the labour force, and changes in the supply of labour shift the LRAS curve as the costs and quality of labour change. The UK population has been rising - it was approximately 67 million in 2018, an increase of over 9 million since 2000. Just over half of this increase in population is explained through net migration, I.e. more people have come to live in the uk than have left it. The extent to which migrants impact on the labour force determines whether firms costs will change as a whole.

Question 73

In the labour market, tell me how the following factor influences the LRAS: health spending increases

Answer 73

An increase in resources in the health sector should mean that workers have fewer days off sick and are active for longer - often beyond traditional retirement ages. However, spending on health might be absorbed into wage increases for staff in the health service, which would have little overall effect on the level of healthcare. Similarly, the majority of healthcare spending goes on the elderly or very young, neither of which are economically active.

Question 74

In the product market, a rightward (or downward) shift in the AS curve could occur in the following ways, list them

Answer 74

Technological advances

Changes in government regulation

Competition policy and reduction in barriers to international trade

Question 75

In the product market, tell me how the following factor influences/ can cause a shift in the LRAS curve: technological advances

Answer 75

Innovation and investment in new ideas tend to reduce costs for all firms. For example, widespread access to the internet increases competition among firms and means that firms can be more streamlined. Buying a book, for example, is now much cheaper online because there are fewer expensive outlets to maintain.

Question 76

In the product market, tell me how the following factor influences the LRAS: changes in government regulation

Answer 76

There are many regulations in the UK economy that have been imposed to try to maintain a disciplined economy, such as the postal and telecommunications services. However, such industries have been increasingly deregulated over the past two decades to increase competition, which in turn imposes its own form of discipline. The net effect is that parcel postage and phone services - costs faced by all firms - have reduced in real terms, shifting the AS to the right (or down)

Question 77

In the Product market, tell me how the following factor influences the LRAS: competition policy and reduction in barriers to international trade

Answer 77

As a country opens up to more trade, competition drives down prices and inefficient domestic firms give way to overseas firms with a comparative advantage. Therefore, as globalisation develops, AS increases.

Question 78

Why do shifts in the SRAS curve occur

Answer 78

Because there is a change in costs of production, but the overall productive capacity remains unchanged. The short run means that there is at least one fixed factor and firms cannot change their overall output unless the factors of production are variable. So short run changes in AS might feed through to long term changes.

Question 79

What does LRAS show

Answer 79

It shows the productive potential of firms when all factors are variable. In the long run, the ability of an economy to produce goods and services to meet demand is based on the state of production technology, the country’s infrastructure and the quantity and quality of factors of production such as labour.

Question 80

Short run ‘supply side shocks’ cause a shift in….

Answer 80

The SRAS curve. Examples include changes in the price of oil or exchange rates.

Question 81

Changes in the quantity or quality of factors of production feed through into a shift in the…

Answer 81

LRAS curve.

Question 82

What is AD

Answer 82

The total amount that is planned to be spent in an economy at any price level

Question 83

What is AS

Answer 83

The output that all firms are willing to supply at any price level

Question 84

What is equilibrium real output and price level

Answer 84

It occurs where AD meets AS

Question 85

What are the components of AD

Answer 85

C + I + G + (X - M) and a change in any one of these will shift the AD curve, with multiplier effects.

Question 86

If AD increases, the price level is likely to…

Answer 86

rise and output may rise, depending on the price elasticity of the the AS curve.

Question 87

Increases in AS tend to…

Answer 87

lower prices or curb rises in prices. Real output is likely to increase, although this depends on the elasticities where the AD and AS curves cross.

Question 88

When house prices rise, is AD likely to rise or fall

Answer 88

AD tends to rise because of the wealth effect

Question 89

Identify four factors that could cause a fall in investment

Answer 89

A fall in investment may be caused by a fall in business confidence, eg if there are expectations that the economy is going to slow down, a rise in interest rates (because this makes borrowing more expensive); a fall in profits (because firms will have less money available for investment); and an increase in the value of the pound against other currencies (because this will make exports more expensive)

Question 90

How would an increase in the UKs trade deficit affect the AD curve

Answer 90

It would cause the AD curve to shift to the left

Question 91

Do all economists draw the AS curve as upward sloping

Answer 91

No, if there is no spare capacity in the economy, the AS curve will be vertical, and classical economists draw the AS curve as entirely vertical in the long run situation. Keynesians draw the AS curve as a combination of horizontal (spare capacity), upward sloping (some bottlenecks) and vertical (full capacity).