Macro Unit 1- Economic Theory

Question 1

Define aggregate supply

Answer 1

Aggregate supply is the total output produced in an economy at a given price level over a given period of time. It is the sine of all industry supply curve in an economy.

Question 2

What does this diagram look like ? Explain this diagram

Answer 2

Look at notes

As output increases, the price level also increases. This is because the higher the price of a good, the higher the incentive for a business to produce the good.

SRAS shows total output when price level can change but assumes prices of all other factors of production (CELL) in the economy are fixed.

Question 3

What happens in the short run for the SRAS?

Answer 3

In the short run an increase in output will involve an increase in a firms costs, which will in turn lead to some firms raising prices. This shows cost push inflation

Question 4

What causes supply side shocks? (A shift in SRAS)

Answer 4

1. Labour costs e.g. income tax
2. Production costs e.g. availability of subsidies
3. Commodity prices- raw materials increase
4. Trade- Exchange rates and tariffs- e.g. cheaper imports

Question 5

What is the Keynesian LRAS theory?

Answer 5

They argue that the economy can be below full capacity in the long run.

• Economy is not always at full employment.
• Can be self-correcting but may take too long so government intervenes
• ‘in the long run we are all dead’- John Keynes
• The economy can be sometimes strong (expansionary) is weak (recession)
• Wages and prices can get stuck

Question 6

What do Keynesian argue the reasons are for output being below full capacity?

Answer 6

1. Wages are sticky downwards
2. Negative multiplier effect. Once there is a fall in aggregate demand, this causes others to have less income and reduce their spending creating a negative knock-on effect
3. In a recession people lose confidence and this save more. By spending less this causes a further fall in demand.

Question 7

What does the Keynes supply and demand curve look like?

Explain this

Answer 7

Look at notes

The curve assumes that prices and wages are fixed until full employment is reached. Before full employment is reached there is spare capacity in the economy and so price level is stable and doesn’t change and increases in AD will not cause any inflationary pressure

Question 8

What is the Neo-Classico LRAS theory ?

Answer 8

The neoclassical perspective believes that in the long run, the economy will fluctuate around its potential GDP and its natural rate of unemployment.

• Assumes everyone is always in employment
• All resources are being fully used
• Economy is self correcting
• Wages and prices are flexible

Question 9

What does the neoclassical AS curve look like?

Explain this

Answer 9

Look at notes

In the neoclassical model, aggregate supply curve is drawn as a vertical line at the level of potential GDP. If AS is vertical, then it determines the level of real output, no matter where the aggregate demand curve is drawn. Over time, the LRAS curve shifts to the right as productivity increases and potential GDP expands.

Question 10

What are the key differences between Keynesian and neoclassical theories of AS in the long run?

Answer 10

The classical model stresses the importance of limiting government intervention and striving to keep markers free of potential barriers to their efficient operation. Whereas, Keynesian argue that the economy can be below full capacity for a considerable time due to imperfect markets and so Keynesian place a greater role for expansionary fiscal policy (government intervention l) to overcome recession.

Question 11

When do trade offs take place on the LRAS curve ?

Answer 11

Keynesian believe that as AD shifts towards full employment, trade offs occur between the price level and unemployment- inflation

Question 12

What did Hayek believe on the post-book crash recovery?

Answer 12

Hayek believed that genuine recovery from a post-boom crash called not just for adequate spending but for a return to sustainable production. Hayek was dismissed as someone who wanted to ‘liquidate labour, liquidate stocks, liquidate the farmers’ and so on. This correspond with the invisible hand theory. According to Hayek the main cause of slumps was excessive credit creation by the banks bad investment

Question 13

What does the business cycle look like? Include annotations

Answer 13

Look at notes

Question 14

What is the liquidity trap?

Answer 14

If interest rates can be lowered these may still have no effect if people cannot borrow.

Question 15

Explain the shape of both the aggregate demand and supply curves

Answer 15

The aggregate demand curve clips downwards from left to right because as price level increases, the real GDP decreases. There is an inverse relationship between the two factors.

Whereas the LRAS curve is both perfectly elastic and inelastic. When price level and real GDP is low, the LRAS is perfectly elastic therefore showing there is a lot of spare capacity and high unemployment. At this point aggregate demand is low and has shifted onwards. However, as the price level increases from AD shifting outwards up the LRAS towards the perfectly inelastic part there is no spare capacity and full employment.

Question 16

Fill in the gaps…

Monetarism emphasises then importance of ……. and influences…… based on the ……

Answer 16

1. The money supply
2. Decisions central banks make
3. Quantity theory of money

Question 17

Equation for monetarism

Answer 17

Money supply x velocity= price level x real GDP

M x V= P x Y

Question 18

What do monetarist believe in the long run?

Answer 18

Monetarist believe that in the long run the ‘absolute amount of money’ in an economy doesn’t matter. It doesn’t influence real output or real employment.

Question 19

What do monetarists believe in the short term

Answer 19

Changes in the rate of inflation can matter. Too much money was being supplied which led to higher economic output- inflation eventually fails to stimulate the economy

Question 20

What does monetarist economics believe about the LRAS?

Answer 20

Friedman a monetarist economics branches of the new classical view and believes spare capacity only exists in the short run and employment will be full in long run. Disagreed with Keynes view on government spending.

Monetarists developed on the classical theory of the LRAS to say that any attempts to influence output through fiscal policy (taxes or government spending) as recommended by Keynes are at best INEFFECTIVE, as expansionary fiscal policy only causes inflation, not an increase in output/productivity.

Question 21

What do monetarists in comparison to Keynes?

Answer 21

Monetarists believe in the control of money and the money supply in the economy while allowing the rest of the market to self-correct, while Keynesians want to increase AD through expansionary policies such as government spending and taxes.

Question 22

Explain the stages and graph of the classical model positive output gap

Answer 22

1. Increase in AD shifts right AD1-AD2 (lower income tax etc)- increase in consumption, investment etc. This is a positive demand shock- PL increased showing demand pull inflation
   - Firms find it hard to recruit labour, buy raw materials. Prices of factor inputs are bid up. Cost push inflation.
   - Consumers find it more expensive- wages haven’t gone up in short run to afford higher prices- less purchasing power
2. Due to inflation the cost for firms increases due to wage price spiral- unemployment increases
3. This will shift SRAS inwards from sras1 to sras2- less incentive to produce. We have returned to YFE/ and originally Y1, output level but with an increase in the price level P2-P3.

Question 23

What are sticky wages?

Answer 23

• Employees wages tend to have a slow response and are not updated in the short run.
• Wages don’t adjust quickly to changes in labour market conditions- these will only adjust in the long run when contracts can be changed based on labour market equilibrium/ trade unions/ inflation/ NMW
• Wages are said to be sticky in the short run

Question 24

Explain the stages and graph of the classical model negative output gap

Answer 24

1. AD shifts onwards from AD1 to AD2- this may be caused by an increase in income tax therefore less disposable income so a decrease in consumption
2. New equilibrium= Y2, P2- AD shifts onwards to a lower output and price level- disinflation
3. SRAS shifts outwards from SRAS1 to SRAS2 e.g. a decrease in commodity goods- incentive to produce for firms.
4. In the long run, we are at the same original real output level, we are back to full employment (producing more goods).

Question 25

Possible reasons why SRAS would shift ?

Answer 25

• Inflexible labour markets (NMW existence, sticky wages, long term employment
• Inflexible product markets due to for example monopoly power

Question 26

What does the Phillips curve show?

Answer 26

It shows the relationship between unemployment and inflation in an economy. The Phillips curve highlights possible trade offs between macroeconomic objectives- achieving low unemployment does not allow for low inflation.

Question 27

Explain the short run phillips curve?

Answer 27

More people working= more disposable income= more consumption= more demand for goods and services= greater output by firms= more employment= more consumer confidence= shift in AD= demand pull inflation= more pressure from employees for higher wages= higher prices to cover high costs of production= cost push inflation.

Question 28

Where is

1. Inflation
2. Deflation
3. Disinflation

On a graph?

Answer 28

1. Look at notes

Question 29

Explain the wage price spiral?

Answer 29

The wage price spiral explains the cause-and-effect relationship between rising wages and rising inflation.

1. Costs rise
2. Employees seek pay rose in order to cover higher living costs
3. Costs of firms rise (labour costs)
   4: firms raise prices in order to cover increased costs- cost push inflation)
4. Employees seek pay rise

Question 30

Explain the Long run Philips curve?

Answer 30

Monetarists accepted that the short run Philips curve existed and be two had a negative correlation- but that in the long run, the Phillips curve was vertical.

In the long run, there was no trade off between unemployment and inflation.

The Long run Phillips curve is a vertical line at the natural rate of unemployment (NRU) so inflation and unemployment are unrelated in the long run.

Question 31

What is the NAIRU?

Answer 31

Non-Accelerating Inflation Rate of Unemployment. The specific unemployment rate at which the rate of inflation stabilises.

Question 32

Correlation between LRPC and classical view

Answer 32

Movement left on classical= positive output gap

Question 33

What did monetarist economists argue happened in the long run for the Phillips curve?

Answer 33

The Phillips curve was criticised by monetarist economists who argued there was no trade off between unemployment and inflation in the long run.

Question 34

What is the difference between nominal and real wages?

Answer 34

Nominal wage= the amount of money you earn per hour/ doesn’t take into account changes in price levels

Real wage= nominal wage adjusted for inflation

Question 35

What is stag inflation?

Answer 35

Persistent high inflation combined with high unemployment and stagnant demand in a country’s economy.

Question 36

What did monetarists argue led to staginflation?

Answer 36

Increasing the money supply just led to a wage inflation spiral and did not help to reduce unemployment. They advocated reducing the money supply and achieving low inflation- any unemployment would just pove temporary.

Question 37

What caused the Philips curve to shift?

Answer 37

1. Supply shocks e.g. the oil crisis of the mid 1970s

2. Changes in people’s expectations about inflation

Question 38

What is money illusion ?

Answer 38

Money illusion occurs when people confuse nominal and real wages when making economic decisions.

Question 39

What is meant by capacity constraints?

Answer 39

When employers can no longer afford to pay their employees this higher wage rate and so they no longer supply extra labour leading to the real output retuning back to its original level.

Question 40

How can supply side policies shift the LRPC to the left (inwards)?

Answer 40

• privatisation
• Deregulation
• reducing income tax rates
• Minimum wage
• migration

Question 41

What is the quantity theory of money ?

Answer 41

In monetary economics, the quantity theory of money states that the general price level of goods and services is directly proportional to the amount of money in circulation, or money supply

Question 42

Criticisms of the quantity theory of money?

Remember MV= PY

Answer 42

1. An increase in the money supply could cause output (T or Y) to increase (increase in input- increase in output), leaving to no change in price level- not fixed. Keynes curve
2. Tautology- saving the same thing twice in different worlds. QTM is tautology as it is calculated in such a way as fo be the same- monetary expenditure= price and velocity of goods traded. The economists are viewed as having made broad assumptions.
3. Velocity isn’t always fixed. Assumption- amount of transactions taking place can be variable in reality- other factors can impact amount of spendings on goods and services e.g. interest rates, ease of transactions e.g. chip and pin
4. All factors of aggregate demand influences price level and not money supply
5. When the economy recovers and velocity of circulation rises, increased money supply is likely to cause inflation (Ad shifts)
6. Weak link between money supply and inflation. Money supply can vary due to changes in the way of managing bank accounts and money.

Question 43

Positives for QTM

Answer 43

In the MV=PT equation V and T are thought to be constant at least in the short term and this the increase in M will lead to a rise in P. Increase in the money supply will raise AD increasing the price level. Prices will have to rise to accommodate the rise in the money supply.