Aggregate Demand And Supply Flashcards
What is aggregate demand?
The total level of expenditure on all domestic goods and services
What is the formula for AD?
C + I + G + X - M
What does aggregate mean?
Combined/overall
What does an aggregate demand graph look like?
Price level is along the y axis and real output is along the x axis. The aggregate demand curve slopes downwards.
Why does the aggregate demand curve slope downwards?
The purchasing power of economic agents rises as price level falls.
What will lead to aggregate demand shifting outwards?
An increase in C, I, G and X. A decrease in M.
Which leads to a shift in the AD curve - exogenous shocks or changes in price level?
Exogenous shocks
What is an exogenous shock?
A change in a variable which affects at least one of the AD components but which itself is outside the AD model.
What causes consumption to increase?
An increase in population, interest rates falling, increase in consumer confidence, rise in real incomes, rising wealth, increase in employment and a decrease in income tax.
When would consumer confidence increase for instance?
When the economy is coming out of a recession or when the price of assets increases.
Why would interest rates falling cause consumption to increase?
People won’t want to save their money if they aren’t going to get anything in return and they are also more likely to take loans if there are low interest rates.
What would cause investment to increase?
A rise in profits, a decrease in corporation tax, investor/business confidence increasing, government policies promoting investment such as subsidies, the level of risk decreasing and falling interest rates.
What would cause government spending to increase?
A change in legislation leading to a rise in government spending.
Why would spending on transfer items not be included in aggregate demand?
This doesn’t show the demand for a good or service and it would also be counted as consumption.
What would cause net imports to increase?
A rise in the UK price competitiveness, a rise in the UK’s non-price competitiveness and the exchange rate.
What is the wealth effect?
This refers to the impact of rising asset prices on both the willingness and ability of consumers to increase their spending on the high street. This is because their confidence in the state of the economy changes.
What does investment include?
Only physical tangible investment.
What is the result of a weaker pound?
We import less and export more.
What does MPW stand for?
Marginal propensity to withdraw
Why do we include export demand which is demand from foreign consumers?
We are not interested in who is demanding as this is the total expenditure on domestic goods and services.
Why do we subtract import expenditure?
It’s a withdrawal - essentially there is lost demand as we could have had it in the UK economy.
Why won’t a cut in taxes mean that government expenditure will decrease?
The government spends what it wants even if it goes into debt.
What is the multiplier effect?
Where an increase in an injection (I, G or X) causes a proportionally greater increase in GDP.
What is MPC?
The proportion of extra income spent on consumer goods is called the marginal propensity to consume.
How is the multiplier (K) calculated?
K = 1/1-MPC
What is MPC + MPW equal to?
1
What is the increase in AD equal to?
Multiplier x injection
What is another way to calculate the multiplier?
K = 1/MPW
What are some evaluation points about the multiplier?
The MPC may not be accurate, the value of it may not be constant overtime as cycles go by, the multiplier process takes time, the multiplier is very hard to measure and isolate from other influences, the impact on GDP depends on the relative position with the AS curve and future changes in tax/spending may cancel out the effects.
What are interest rates?
The price of money.
What do savers prefer in terms of interest rates?
High interest rates.
What do interest rates represent for borrowers?
The cost of borrowing.
What do interest rates represent for savers or lenders?
The rewards for saving.
Why would changing interest rates not necessarily impact individuals and their mortgage repayments?
Some people have a fixed rate mortgage and their repayments are not affected by the Bank of England base rate and commercial banks such as Natwest may not follow the Bank of England interest rate.
What effect does demand increasing for the pound have?
It creates a stronger sterling exchange rate.
Why won’t an increase in UK interest rates necessarily lead to a stronger sterling exchange rate?
There are many other factors that affect UK interest rates and they could lead to the pound becoming weaker and also if other countries increase their interest rates by a higher amount then the relative interest rate for the UK has actually fallen.
What is aggregate supply?
The total level of real output of all domestic goods and services.
What does the classical model say will happen in the long run?
Wages and prices are flexible ensuring that the economy always operates at the full capacity level.
What does the Keynesian model say about wages in the long run?
Wages and prices are ‘sticky downwards’ meaning that wages can’t fall and are hard to fall due to things such as strikes. Unemployment could persist even in the long run.
What do the classical model and the Keynesian model both agree about?
That unemployment may persist in the short run. Money wage rates and all factor input prices are fixed.
What will firms do if they want to produce more output in the short run?
They are unlikely to hire extra workers as this is costly so they will ask their workers to work overtime, this requires extra overtime pay which will result in firms choosing to increase their prices.
How is the full employment level of output denoted?
YFE
According to the classical model, in the long run will we always operate at the full employment level and why is this the case?
Yes as wages will self-adjust.
In the long run, what will an effective shortage of labour cause?
An upward pressure on wages.
How might firms respond to a lack of demand in the short run?
By reducing wages/accepting lower productivity from workers or by firing workers.
What will surpluses in the labour market cause in the long run and what effect does it have on the SRAS curve?
A downwards pressure on wages. This causes the SRAS curve to shift downwards.
According to Keynesian economics, what will happen to the economy when it is at full capacity at high levels of output and is this also the case for classical economics?
It will be represented by a perfectly inelastic line which is what classical economists believe as well.
What is possible in Keynesian economics?
For the economy to operate below the full capacity level.
What would cause increases in the full employment level?
Immigration, an increase in the retirement age and advances in technology.
What would cause the AS curve to shift to the right?
If YFE increases and this could be caused by having more factors of production or having a more highly productive set of factors of production (essentially things that shift the PPF outwards).
What is productivity?
The value of output per unit of factor input.
What does an increase in the costs of production do?
YFE does not change however AS would shift up as price levels become higher at every level of output.
What would a reduction of income tax lead to?
Inflow of immigration workers, an increase in consumption and the economically inactive may start to become a part of the working population.
Why is there a positive relationship for the AS curve?
As price level increases, firms have more of an incentive to expand output as they will become more profitable.
Why is there an inverse relationship for AD?
When the price of goods in the economy fall, there is more demand for those goods.
Why is there a full employment level?
We only have a certain amount of of the four factors of production which limits us.
What does the full employment level show?
The maximum that can be produced using all the factors of production that are available.
What is economic growth and is an increase in real output good for ths objective?
This is defined as the rise in the level of real output produced in an economy. If real output increases then this is good for economic growth.
How does an increase or a decrease in price level affect the target of low and stable inflation?
If price level increases then this is generally bad for the price stability objective, however when price level moves downwards this is usually better for the price stability objective. On the other hand too big a movement downwards could cause deflation which is bad.
Is an increase in real output good for employment levels?
If output increases, then more workers are needed to produce this output as labour is a derived demand so whenever output increases, this is good for the full employment objective.
Is real output increasing good for the balance of payments?
An increase in real output requires more workers to produce this output so employment rises. This means that average income is higher and so more will be spent on imports. The economy will therefore see a larger BoP deficit. The objective is not met when real output increases as a larger deficit is made.
What is the largest component of aggregate demand and how much does it account for?
Consumption and it accounts for 60-70% of aggregate demand.
What do C, I, G, X and M stand for in AD?
C = consumption, I = investment, G = government expenditure, X = export earnings and M = import expenditure
How much does investment comprise of AD?
15%
What does a shift in AD show?
How real output has changed independently of the price level.
Why would interest rates falling cause investment to increase?
Firms are more likely to borrow money as the cost of borrowing is lower and it makes it more worthwhile for firms to take out a loan in order to buy capital goods.
What would cause an increase in UK price competitiveness?
A fall in the sterling exchange rate and a fall in interest rates.
What would cause an increase in the UK’s non-price competitiveness?
Better quality goods, innovation, technology and branding.
What is the general price level?
A weighted basket of all prices in the UK economy.
What is GDP?
The total output of goods and services produced by all firms in the UK economy.
How will increasing consumer confidence lead to consumption increasing?
If consumers feel optimistic about the general state of the economy and about their own job prospects, they will tend to spend more of their income and save less of it.
Why do rising incomes cause consumption to increase?
This will give consumers greater purchasing power so the demand for all goods and services should rise as a result.
