Macro 3: Determinants of AD and SRAS

Question 1

What is aggregate demand?

Answer 1

The total demand for a country’s goods and services at a range of price levels over a given period of time.

Question 2

What is aggregate supply?

Answer 2

The total supply of goods and services within an economy at a range of price levels over a given period of time.

Question 3

What does the aggregate demand and aggregate supply diagram represent?

Answer 3

The total quantity of all goods and services in an economy that all consumers and producers are willing and able to buy or produce at a range of price levels.

Question 4

What can the curves in an AD and AS diagram represent?

Answer 4

The capacity of the economy, the rate of inflation and the output of the economy (GDP).

Question 5

What happens to AD and AS when price levels rise?

Answer 5

Consumers are willing and able to buy fewer goods and services and producers are willing to provide more.

Question 6

What are the 4 main sources of demand within an economy that aggregate demand is composed of?

Answer 6

Consumption (C): Spending on goods and services by households.
Government spending (G): Spending on goods and services and investment by the government.
Investment (I): Spending on capital goods by firms. These are goods that are not immediately consumed but instead will continue to be used in future.
Net Exports (X-M): Total spending on exports minus total spending on imports.

Question 7

Why does the AD curve slope downwards?

Answer 7

The price of goods and services constitutes a smaller proportion of their income. The government can afford to supply more government services. Firms invest in more capital equipment as it’s cheaper so they’re likely to make more profit.

Question 8

What does anything that causes an increase or decrease in any of the components of AD constitute?

Answer 8

An increase or decrease in AD.

Question 9

What does the short-run aggregate supply curve show?

Answer 9

How much output an economy can produce at a range of price levels. It combines the output of all goods and services all the producers in an economy are willing to produce at a range of price levels in a given period of time, assuming fixed availability of factors of production.

Question 10

What does the ‘price level’ mean?

Answer 10

An aggregation of the price indices for all goods and services produced in the economy and could be understood as the CPI or RPI.

Question 11

What is the short run?

Answer 11

In macroeconomics, it assumes the quantity of factors of production available in the economy is fixed. Individual firms can source more factors from within the finite pool available of factors of production.

Question 12

What factors and phenomena explain the shape of the supply curve?

Answer 12

Scarcity of raw materials.
Diminishing returns- each additional worker increases output less than the last worker.

Question 13

What do higher prices do to the AD curve?

Answer 13

Goods and services become less affordable so there’s a contraction in demand.

Question 14

What do lower interest rates do to the AD curve?

Answer 14

It’s cheaper to borrow which reduces the incentive to save, so spending and investment increase. The curve shifts outwards (rises).

Question 15

What do lower taxes do to the AD curve?

Answer 15

This means consumers have more disposable income, so the curve shifts outwards (rises).

Question 16

What does an increase in government spending do to the AD curve?

Answer 16

The curve shifts outwards (rises).

Question 17

What does depreciation in a currency do to the AD curve?

Answer 17

This means imports are more expensive, and exports are cheaper, so AD increases.

Question 18

Why does the AS curve slope upwards?

Answer 18

At a higher price level, producers are willing to supply more because they can earn more profits.

Question 19

What leads to movements along the AS curve?

Answer 19

Only changes in the price level, which occur due to changes in AD.

Question 20

What happens to SRAS if AD increases?

Answer 20

There’s an expansion in the SRAS.

Question 21

What happens to SRAS if AD decreases?

Answer 21

There’s a contraction in the SRAS.

Question 22

What does increased real disposable income do to the AD curve?

Answer 22

It decreases savings and increases consumption so there’s a shift outwards in the AD curve.

Question 23

What do high interest rates do to the AD curve?

Answer 23

It encourages saving because the rate of return on savings increases, and borrowing is also increased. The cost of debt is higher, like with mortgages so the disposable income is reduced. The AD curve shifts inwards.

Question 24

What does low consumer confidence do to the AD curve?

Answer 24

It can be low because people fear a recession coming, losing their jobs etc., more saving and less spending is encouraged. The AD curve then shifts inwards.

Question 25

What is the equation for AD?

Answer 25

Consumption + Investment + Government spending + (Exports - Imports)

Question 26

What causes the SRAS curve to shift?

Answer 26

Changes in the condition of supply.

Question 27

How do higher wage rates affect the SRAS curve?

Answer 27

Higher wage rates increase the overall cost of production for businesses. When wages increase, firms need to spend more on labour to produce the same quantity of goods and services. This causes the SRAS curve to shift inwards because higher costs decrease the profitability of producing goods and may lead to a decrease in output. So, at any given price level, firms are willing to produce fewer goods and services because their production costs have risen.

Question 28

How does an increase in the cost of raw materials affect the SRAS curve?

Answer 28

The overall cost of production for businesses is higher. When the prices of raw materials rise, firms need to spend more on inputs to produce the same quantity of goods or services. This increase in production costs tends to reduce short-run aggregate supply because higher costs decrease the profitability of producing goods and may lead to a decrease in output. The SRAS curve shifts inwards, meaning that at any given price level, firms are willing to supply fewer goods and services because their production costs have risen. Firms could also reduce their output to maintain profit margins, so there’s a lower quantity supplied at each price level, hence an inwards shift of SRAS.

Question 29

How do higher taxes and subsidies affect the SRAS curve?

Answer 29

Higher taxes can increase firms’ production costs. This results in the SRAS curve shifting inwards, reducing the quantity of goods and services supplied at any given price level. Increased taxes can also reduce the profitability of producing goods or services. Firms might respond by scaling back production, leading to a decrease in the SRAS curve.
Subsidies reduce the cost of production for businesses. This gives firms an incentive to produce more at any given price level, leading to an outward shift of the SRAS curve. This means that more goods and services are supplied at each price level.

Question 30

How does an increase in productivity affect the SRAS curve?

Answer 30

Increased productivity means more output is being produced with the same amount of inputs. Firms can thus produce more goods and services at any given price level. This leads to an outwards shift of the SRAS curve, indicating that firms are willing and able to supply more goods and services at various price levels. Higher productivity also leads to lower production costs which gives firms the incentive to supply more goods and services, leading to an outwards shift in the SRAS curve.

Question 31

What is the relationship between consumption and disposable income?

Answer 31

Disposable income is the money that households have left from their salary/wages after they have paid their taxes and have received any transfer payments/benefits.
If taxes rise, DI falls and vice versa.
If wages rise, DI also rises.
If transfer payments (eg. unemployment benefits) rise then DI also rises.
Consumption increases as disposable income increases
Consumption decreases as disposable income decreases

Question 32

What is the relationship between saving and consumption?

Answer 32

Disposable income can either be saved or spent on goods/services.
When savings fall, consumption rises.
When savings rise, consumption falls.
The household savings ratio calculates household savings as a proportion of household income
This percentage is often low when an economy is booming and full of confidence - and vice versa.

Question 33

What is the relationship between interest rates and consumption?

Answer 33

Interest rates are the cost of borrowing and the reward for saving.
If interest rates rise, there’s a greater incentive to save so consumption falls.
If interest rates rise, there’s higher monthly repayment on loans/mortgages so consumption falls.

Question 34

What is the relationship between consumer confidence and consumption?

Answer 34

In a strong economy, consumers feel confident about receiving regular salary payments so there’s more consumption and less saving.
Less consumption and more saving in a weak/recessionary economy as consumers feel less secure in their jobs.

Question 35

What is the relationship between consumer wealth and consumption?

Answer 35

If consumer wealth increases, so does consumption.
If property/share prices rise, consumer confidence increases so higher marginal propensity to consume. More borrowing means more consumption.

Question 36

What does investment do to an economy?

Answer 36

It increases the capacity (production possibilities) of an economy, meaning increased economic growth.

Question 37

What is depreciation?

Answer 37

The decrease in the monetary value of a capital good (asset) over time.

Question 38

What is gross vs. net investment?

Answer 38

Gross investment is the total amount of spending on capital goods.
Net investment is gross investment - depreciation.

Question 39

What is the influence of economic growth on investment?

Answer 39

Increasing growth means higher output so higher profits. The faster the economic growth, the greater the urgency to invest.

Question 40

What is the influence of interest rates on investment?

Answer 40

Decreasing interest rates encourage investment.

Question 41

What are the four influences on investment?

Answer 41

Interest rates, demand for exports, government intervention/regulation and economic growth.

Question 42

What is the influence of demand for exports on investment?

Answer 42

If higher demand, firms will invest more to meet the global demand.
If the exchange rate weakens, demand for exports rises as goods seem cheaper to foreigners.

Question 43

What is the influence of government intervention/regulation on investment?

Answer 43

Increased government intervention can increase investment, eg. subsidies.
Increased government regulation decreases investment because it raises costs of production for firms and can lower profits.

Question 44

What happens to the trade balance if UK real income rises?

Answer 44

Consumers buy more so more imports so (X-M) weakens.

Question 45

What happens to the trade balance if real income increases abroad?

Answer 45

Foreigners buy more UK products so exports rise and (X-M) strengthens.

Question 46

What happens to the trade balance if the UK £ appreciates?

Answer 46

UK goods are more expensive for foreigners so exports decrease. Consumers’ money has more value abroad so imports rise. (X-M) strengthens.
Opposite happens if £ appreciates.

Question 47

What happens to the trade balance if the world economy booms?

Answer 47

There’s increased demand for UK exports so (X-M) strengthens.
Opposite happens if world economy slows.

Question 48

What’s the difference between SRAS and LRAS?

Answer 48

SRAS means at least one factor of production is fixed. It’s influenced by changes in the costs of production or productivity.
LRAS is influenced by changes in the productive capacity of the economy. This means a change in the quality or quantity of factors of production. A change in productive capacity is equivalent to a shift of the PPF.
Long term economic growth requires the productive capacity of the economy to increase.

Question 49

Which factors influence SRAS?

Answer 49

Costs of raw materials/ energy
Tax rates
Exchange rate

Question 50

How does an increase in costs of raw materials shift SRAS?

Answer 50

This means higher input costs so less goods/services can be produced with the same amount of money, so there’s less output. This shifts SRAS left.

Question 51

How does an increase in tax rates shift SRAS?

Answer 51

This means firms have more to pay so input costs rise, output falls so SRAS shifts left.

Question 52

How does an appreciating exchange rate shift SRAS?

Answer 52

The pound is stronger so imports are cheaper, decrease in input costs so more output. SRAS shifts right.