macro 3.2- variations in economic activity- AD/AS

Question 1

define aggregate demand

Answer 1

the total level of planned spending in the economy by consumers (C), firms (I), government (G), and foreigners (X-M) over a period of time (usually one year) at different price levels

Question 2

define aggregate supply

Answer 2

the total planned production at different price levels.

Question 3

state the equation for AD

Answer 3

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

Question 4

C

Answer 4

consumption

Question 5

I

Answer 5

investment

Question 6

G

Answer 6

government expenditure

Question 7

X

Answer 7

exports

Question 8

M

Answer 8

imports

Question 9

(X-M)

Answer 9

net exports

Question 10

draw an aggregate demand curve

Answer 10

flashcard 1

Question 11

what do movements along the AD curve show?

Answer 11

as price level rises, the level of Real GDP falls and vice versa

Question 12

what are shifts in the AD curve caused by?

Answer 12

changes in any of the AD components (C, I, G, (X-M), ceteris paribus

Question 13

Why does the AD curve slope downwards? [3]

Answer 13

1. The income effect; at a lower PL, consumers are likely to have higher disposable income and therefore spend more.
2. The substitution effect; lower PL in the UK= UK goods will become relatively more competitive, leading to higher exports. Exports is a component of AD so AD will be higher.
3. Wealth effect; At a lower price level, interest rates usually fall, and this causes higher AD.

Question 14

state/explain the 6 determinants of C as an AD component

Answer 14

• consumer confidence
• interest rates
• wealth
• income taxes
• level of household indebtedness
• expectations of future PL

Question 15

explain how consumer confidence affects AD

Answer 15

A boost in consumer confidence increases aggregate demand and a drop in consumer confidence decreases aggregate demand.

Question 16

explain how interest rates affect AD

Answer 16

higher IR:
- becomes more “expensive” to borrow money
- consumer spending/investment fall
- AD falls

Question 17

state/explain the 5 determinants of I as an AD component

Answer 17

• interest rates
• business confidence
• technology
• business taxes
• level of corporate indebtedness

Question 18

define an interest rate

Answer 18

the amount a lender charges a borrower . it is a percentage of the principal (the amount loaned)

Question 19

state/explain the 2 determinants of G as an AD component

Answer 19

• political priorities (eg. subsidising education, green companies)
• economic priorities (eg. reducing inflation)

Question 20

state the 3 determinants of X-M as an AD component

Answer 20

• income of trading partners
• exchange rates
• trade policies

Question 21

explain income of trading partners as an AD determinant

Answer 21

• increasing the incomes of our closest trading partners means those people would buy more of our stuff, so our exports would increase
• AD increases

Question 22

explain exchange rates as an AD determinant

Answer 22

an increase in the exchange rate will tend to reduce AD as exports will fall and imports increase.

Question 23

define short run aggregate supply

Answer 23

the short run is the time period where factor costs are fixed (ie the unit cost of land, labour, capital and enterprise are fixed).

Question 24

state the 2 determinants of the SRAS curve

Answer 24

• costs of FOPs
• indirect taxes

Question 25

state 5 examples of changes in FOPs

Answer 25

• technology
• skills
• migration
• wage settlements
• commodity prices

Question 26

describe how indirect taxes would affect the SRAS curve

Answer 26

an effect similar to a rise in production costs (curve will shift left)

Question 27

monetarist/new classical view of the LRAS curve (flashcard 3)

Answer 27

LRAS inelastic as wages/prices flexible due to price mechanism:
- all those willing and able to get a job at the WR will have one
- any unemployment is voluntary
SO output will always be at full employment independent of the PL

Question 28

Keynesian view of the LRAS curve (flashcard 4)

Answer 28

LRAS elastic in long-term – the economy can be below full capacity for a long time unless supply-side initiatives (eg educational changes) are taken

Question 29

Describe a negative output gap (flashcard 5), or deflationary/recessionary gap:

Answer 29

• actual output (real GDP) is lower than potential output (Yf)
• caused by decrease in AD

Question 30

describe a positive output gap (flashcard 5), or inflationary gap

Answer 30

• actual output (real GDP) is greater than potential output (Yf)
• caused by increase in AD

Question 31

state 4 possible causes of shifts in the AS curve over the long run

Answer 31

• changes in the quantity/quality of FOPs
• improvements in technology
• increases in efficiency
• changes in institutions

Question 32

describe a readjustment to equilibrium in the monetarist/classical model after a drop in AD

Answer 32

1. market is at an equilibrium at P1F1
2. AD falls from AD1 to AD2. causing:
   
   • P1 to fall to P2
   • Yf to fall to Y2
   • negative output gap
3. demand for labour falls from D1 to D2
4. Price mechanism ensures new equilibrium at W2Q2
5. lower wages mean lower FOPs, increasing SRAS so curve shifts to right
6. new equilibrium found at P3Yf

Question 33

describe equilibrium in a Keynesian model

Answer 33

• there will be a persistence of deflationary/recessionary gaps: the equilibrium level of output may not equal the full employment level of output

Question 34

state the assumptions behind the Keynesian model

Answer 34

• wages are ‘sticky downwards’ so workers may refuse lower wages due to trade unions, minimum wage laws, money illusion.
• price mechanism will not work (govt required to take action)

Question 35

define the money illusion

Answer 35

people think in nominal terms

Question 36

state the assumptions behind the classical model

Answer 36

• short run unemployment can occur but is a temporary phenomenon; wages are flexible and so will fall, and the labour market will move back into equilibrium
• long run unemployment will be ‘voluntary’