macro 3.2- variations in economic activity- AD/AS Flashcards
define aggregate demand
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
define aggregate supply
the total planned production at different price levels.
state the equation for AD
AD= C + I + G + (X-M)
C
consumption
I
investment
G
government expenditure
X
exports
M
imports
(X-M)
net exports
draw an aggregate demand curve
flashcard 1
what do movements along the AD curve show?
as price level rises, the level of Real GDP falls and vice versa
what are shifts in the AD curve caused by?
changes in any of the AD components (C, I, G, (X-M), ceteris paribus
Why does the AD curve slope downwards? [3]
- The income effect; at a lower PL, consumers are likely to have higher disposable income and therefore spend more.
- 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.
- Wealth effect; At a lower price level, interest rates usually fall, and this causes higher AD.
state/explain the 6 determinants of C as an AD component
- consumer confidence
- interest rates
- wealth
- income taxes
- level of household indebtedness
- expectations of future PL
explain how consumer confidence affects AD
A boost in consumer confidence increases aggregate demand and a drop in consumer confidence decreases aggregate demand.
explain how interest rates affect AD
higher IR:
- becomes more “expensive” to borrow money
- consumer spending/investment fall
- AD falls
state/explain the 5 determinants of I as an AD component
- interest rates
- business confidence
- technology
- business taxes
- level of corporate indebtedness
define an interest rate
the amount a lender charges a borrower . it is a percentage of the principal (the amount loaned)
state/explain the 2 determinants of G as an AD component
- political priorities (eg. subsidising education, green companies)
- economic priorities (eg. reducing inflation)
state the 3 determinants of X-M as an AD component
- income of trading partners
- exchange rates
- trade policies
explain income of trading partners as an AD determinant
- increasing the incomes of our closest trading partners means those people would buy more of our stuff, so our exports would increase
- AD increases
explain exchange rates as an AD determinant
an increase in the exchange rate will tend to reduce AD as exports will fall and imports increase.
define short run aggregate supply
the short run is the time period where factor costs are fixed (ie the unit cost of land, labour, capital and enterprise are fixed).
state the 2 determinants of the SRAS curve
- costs of FOPs
- indirect taxes
state 5 examples of changes in FOPs
- technology
- skills
- migration
- wage settlements
- commodity prices
describe how indirect taxes would affect the SRAS curve
an effect similar to a rise in production costs (curve will shift left)
monetarist/new classical view of the LRAS curve (flashcard 3)
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
Keynesian view of the LRAS curve (flashcard 4)
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
Describe a negative output gap (flashcard 5), or deflationary/recessionary gap:
- actual output (real GDP) is lower than potential output (Yf)
- caused by decrease in AD
describe a positive output gap (flashcard 5), or inflationary gap
- actual output (real GDP) is greater than potential output (Yf)
- caused by increase in AD
state 4 possible causes of shifts in the AS curve over the long run
- changes in the quantity/quality of FOPs
- improvements in technology
- increases in efficiency
- changes in institutions
describe a readjustment to equilibrium in the monetarist/classical model after a drop in AD
- market is at an equilibrium at P1F1
- AD falls from AD1 to AD2. causing:
- P1 to fall to P2
- Yf to fall to Y2
- negative output gap
- demand for labour falls from D1 to D2
- Price mechanism ensures new equilibrium at W2Q2
- lower wages mean lower FOPs, increasing SRAS so curve shifts to right
- new equilibrium found at P3Yf
describe equilibrium in a Keynesian model
- there will be a persistence of deflationary/recessionary gaps: the equilibrium level of output may not equal the full employment level of output
state the assumptions behind the Keynesian model
- 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)
define the money illusion
people think in nominal terms
state the assumptions behind the classical model
- 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’
