Th2.2: The AD Curve

Question 1

The AD curve is the same as the demand curve for an individual market, but instead…

Answer 1

it shows the relationship between price level and real GDP

Question 2

Why is the AD curve downwards sloping?

Answer 2

a rise in prices causes a fall in GDP

Question 3

What are the four main reasons that a rise in prices causes a fall in GDP?

Answer 3

income effect
substitution effect
real balance effect
interest rate effect

Question 4

How does the income effect lead to a contraction in demand?

Answer 4

as a rise in prices is not matched straight away by a rise in income, people have lower real incomes so can afford to buy less

Question 5

How does the substitution effect cause AD to contract?

Answer 5

if prices in the UK rise, less foreigners will want to buy British exports and more UK residents will want to buy more imported goods because they are cheaper. the rise in imports and decrease in exports will decrease net exports.

Question 6

How does the real balance effect cause a contraction in AD?

Answer 6

a rise in prices will mean that the amount of people have saved up will no longer be worth as much and so will offer less security. as a result they will want to save more and so reduce their spending

Question 7

How does the interest rate lead to a contraction in AD?

Answer 7

rising prices mean firms have to pay workers more and so their is a higher demand for money. if supply stays the same, then the ‘price of money’ (interest rates e.g) will rise because of higher demand. higher interest rates - save more, borrow less and decrease investment