How the Macroeconomy Works, Circular Flow of Income, AD/AS Analysis and Related Concepts

Question 1

What is aggregate supply?

Answer 1

Total value of output (goods and services) of the economy at a given price level at a given point in time

Question 2

what is meant by short run?

Answer 2

we assume all factors of production are fixed in the short run with the exception of labour, as frims may higher more workers or maximise their resources productivity to meet AD.

Question 3

What causes the movements along the SRAS curve?

Answer 3

1) a rise in price level leads to an expansion in SRAS
2) changes in AD lead to movements along the SRAS curve.
3) if prices level falls, there is a contraction in SRAS.

Question 4

What factors affect SRAS?

Answer 4

(when there is a change in the costs of production SRAS changes)
Wages - wages increase, firms will substitute labour for capital or simply less to maintain margins.

The price of raw materials - high raw material prices increase the cost of production reducing SRAS.

Productivity - the productivity of land labour and capital can change in the short run.

Taxes & subsidies -increase in tax rate means SRAS decreases, increase in subsidies means SRAS will increase

Exchange rates & imports - strong currency increases seas (cheaper imports).

Question 5

What shifts the SRAS curve?

Answer 5

An increase in costs of production, SRAS to SRAS2. (shift left)
A decrease in costs of production, SRAS to SRAS1. (shift right)

Question 6

What is the classical LRAS curve?

Answer 6

Straight line - Y is the maximum capacity of the economy for production, there is full employment and all resources are used efficiently.

Question 7

What factors affect LRAS?

Answer 7

Land - more available land or primary resources will increase the productive potential and LRAS.

Labour - a large labour force & trained workers increases output & LRAS. Geographical (occupational) mobility of labour gives more production flexibility.

Capital (tech) - increase in quality, quantity and productivity (through tech or R&D) will boost LRAS.

Enterprise - an incentive to invest in products or to start businesses will boost LRAS

Government intervention - regulatory frameworks improve the level of competition in different markets, greater competition drives efficiency among firms to maximise profit.

Question 8

What shifts the LRAS curve?

Answer 8

A decrease in the quantity or quality of the FOP shifts LRAS to LRAS2. (to the left)
An increase in the quantity or quality of the FOP shifts LRAS to LRAS1. (to the right)

Question 9

What does the classical view of the LRAS suggest?

Answer 9

Implies that the economy always operates at the maximum its resources will allow.

Classical economists believe the markets will always function efficiently over the long run, so an economy will produce on the outer boundary of its PPC hence the curve is vertical marking a maximum limit of production.

Question 10

What does the Keynesian view of the LRAS suggest?

Answer 10

Keynes believed an economy could be in equilibrium below full employment.

His 1930s study of the great depression concluded that the LRAS curve was upward-sloping and did have a vertical section like the classical LRAS. Though at times an economy could settle at an output level below full employment.

Question 11

How does the Keynesian diagram operate?

Answer 11

A - unused capacity, the graph is horizontal and firms can increase output without increasing costs.

B - limited spare capacity, the graph starts to slope and the economy nears full employment as firms find it harder to attract scarce resources as prices rise.

C - full capacity, the graph is vertical and there is full employment as all resources are used.

Question 12

What shifts the keneysain LRAS curve?

Answer 12

Any change in the quality or quantity of FOP will shift LRAS (like with the classical curve).

Question 13

Which LRAS curve do you use?

Answer 13

Keynesian - arguably more realistic, a larger range of explanations regarding the behaviour of an economy. They aren’t perfect, they are models and both have their problems and assumptions.

Question 14

What is aggregate demand?

Answer 14

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

Question 15

What is the multiplier effect?

Answer 15

When an initial injection into the economy or circular flow of income causes a larger, final increase in the level of RNO.

Question 16

What is the formula for GDP?

Answer 16

C+I+G+(X-M) - increase in the components of AD leads to rise in the circular flow of income.
Consumption - flows between household firms that are impacted by savings and taxes.
Investment - inflow
government expenditure- injection
Imports - injection… net exports - withdrawal

Question 17

How do you calculate the multiplier?

Answer 17

K = change in Y/change in J
K - the multiplier. Y - RNO. J - Injections

Question 18

What is the negative multiplier effect?

Answer 18

• Cuts in spending or increases in taxes will lead to a negative multiplier and fall in GDP
• the multiplier size will be dependent on the MPC, a high MPC feeds through to a higher value on the multiplier.
• A high MPS will lead to a lower value of the multiplier.

Question 19

What factors affect the size of the multiplier?

Answer 19

Interest rates - if they are high, consumption may not rise significantly as additional income may be saved rather than spent.

Tax rates - withdrawal, if tax rates are high, consumers are deterred from spending, or they have less disposable income to consume products.

Imports - UK has a high propensity to consume imports. If an increase in disposable income is spent on imported goods, it would count as a withdrawal and national income won’t rise as anticipated.

Spare capacity - little spare capacity, means an increase in AD may not be met by firms, especially in the short run. The multiplier effect will be limited and inflation may occur.

Question 20

What is macroeconomic equilibrium?

Answer 20

macroeconomic equilbrium occurs when AD = AS.

If there are changes in AD or AS you could also see a change in price unemployment & inflation.

Question 21

What shifts AD, SRAS & LRAS?

Answer 21

AD - any change in the components of AD ( C + I + G + (X-M))

SRAS - any change in the costs of production

LRAS (keynes & classical) - Any change in the quality, quantitiy or productivity of factors of production.

Question 22

how may AD shift in a short run diagram?

Answer 22

1) begin at equilibrium
2) if consumption increases, AD shifts to the right (AD to AD1)
3) there will be an expansion along the SRAS curve resulting in a new equilibrium price level of P1 and output of Y1

Question 23

how may SRAS shift in a short run diagram?

Answer 23

1) Begin at equilibrium
2) if there is an increase in the costs of raw materials used in the production process means SRAS shidts to the left
3) there is a contraction along the AD curve. There will be a new equilibrum price level of P1 and output of Y1

Question 24

how may AD shift in a long run diagram?

Answer 24

1) begin at equilibrium
2) if exports increase, AD will shift to the right (AD to AD1)
3) there will be an expansion along the LRAS curve resulting in a new equilibrium price level of P1.
4) Crucially, RNO will remain at Y as all factor resources have been employed and remain unchanged. Any increase in AD will only cause inflation.

Question 25

how may LRAS shift in a long run diagram?

Answer 25

1) Begin at equilibrium
2) if there is a discovery of a primary raw material, LRAS will shift to the right (LRAS to LRAS1, economic growth will occur)
3) there will be an expansion along the AD curve resulting in a new equilibrium price level of p1.
4) RNO increases to Y1 as there has been an increase in the quantity of factor resources. The economy benefits from a higher level of RNO and lower price level.

Question 26

how has research on long run shifts affected the macroeconomic policy?

Answer 26

• classical economist advocate and support economic policies that improve long run AS
  However it doesnt suggest LRAS is unimprtant…
• if AD increases with no attention given to improving the quality and quantitiy of factor resources, then inflation will occur and damage economic growth.

Question 27

what is keynesian Long run equilibrium?

Answer 27

Keynes believed the economy could settle in equilibrium below the full employment level of output

• Hence, the distance Y-FE represents spare capacity in the economy
• There is likely to be unemployment because of a deficiency of AD

Question 28

how may AD shift in a long run Keynesian diagram?

Answer 28

1) begin at equilibrium
2) if consumption increases, AD will shift to the right.
3) there will be an expansion along the LRAS curve. the price level will increase to P1 as the conomy is close to full employment and resources are more scarce.
4) RNO increases to Y1 but spare capacity of Y1-FE remains

Question 29

how may AD shift in a long run Keynesian diagram (2)?

Answer 29

5) if AD increases without any increases in LRAS, FE equilibrium will be reached and any increases in AD above AD2 are purely inflationary.

6) if AD is depressed at AD3 and AD increases to AD4, the price level will be unchanged as there remains a significant amount of spare capacity in the economy. Increases in AD can be absorbed without increases in the price level.

7) any policies to increase LRAS would simply enhance spare capacity and leave the equilibrium level of employment unchanged.

Question 30

how may LRAS shift in a long run Keynesian diagram?

Answer 30

1) Begin at equilibrium
2) if there is an increase in capital efficiecy, LRAS will shift to the right.
3) There will be an expansion alonf the AD curve. The price level will decrease as available factor resources increase and scarcity reduces.
4) RNO increases to Y1 and max productive potential increases to FE1, indicating economic growth.

Question 31

how has research on keynesian long run shifts affected the macroeconomic policy?

Answer 31

keynesian economist advocate and support economic policies that improve and manage AD.

That is not to say LRAS in not unimportant however…

• if the economy is operating below its full potential ( E.G recession) keynesian economist will focus attention on policies that stimulate the components of AD

Question 32

How do demandside and supply side shocks affect the economy?

Answer 32

• The UK operates in a global framework, other nations economic performance impact the UK
• this effects the strength of the UK economy, hence shocks affect open economies larger.

They are intergrated in the global economy so there is greater impact when major global events occur.