Theme 2 - Aggregate Demand and Aggregate Supply

Question 1

Define aggregate demand

Answer 1

the total amount of spending on goods and services in an economy during a period of time

Question 2

identify the 4 components of AD

Answer 2

1 consumption (C)
2 investment (I)
3 government spending (G)
4 net exports (X-M)

Question 3

how significant are each of the 4 components of AD

Answer 3

consumption (65%)
Investment (15%)
Government Expenditure (15-20%)
and the remainder is net exports

Question 4

What does the AD curve look like

Answer 4

general price level on y axis, real GDP on x axis, and the AD line is a standard, straight line with a negative gradient

Question 5

why is an AD curve down sloping

Answer 5

• THE WEALTH EFFECT, as price level rises, real income falls and so less can be consumed
• THE INTEREST RATE EFFECT: as price level rises, the level of real income falls so consumers are less likely to save their income. If the level of savings falls, then the funds available for investment also falls, this pushes up the interest rate which means that investment falls therefore AD falls.
• THE EXCHANGE RATE EFFECT: as the price level rises, UK exports look less competitive compared to foreign goods, so exports fall and imports rise meaning that net exports falls therefore AD falls, moreover as the price level increases, interest rates rise which attracts hot money flows, and the currency appreciates causing exports to fall and imports to rise.

Question 6

what would cause movement along an AD curve

Answer 6

a change in the price level is the only thing that causes a contraction or expansion in AD

Question 7

what would cause a shift in the AD curve

Answer 7

a change that affects any or all of the components of AD would shift the whole curve, or a change in the conditions of demand

Question 8

Name 5 factors that would increase consumption

Answer 8

• Real incomes rising: if wages rise faster than price level, real income will rise which leads to increased consumption depending on the Marginal Propensity to Consume (MPC)
• Interest rates falling: if they do it is less expensive to purchase goods on credit so consumption will rise, loan repayments will also fall leaving more income for consumption. The reward for saving will also diminish so consumers would rather consume.
• Asset prices/Wealth: if assets like stocks and shares or house prices rise in value then consumers feel more wealthy so will consume more, this is called the wealth effect.
• Job security/ confidence : if consumers feel secure in their job or confidence in the economy is high then they would rather spend.
• Personal taxation falling: if income tax or national insurance falls then disposable income will rise, so AD will

Question 9

define investment

Answer 9

the purchase of fixed capital such as machinery (does not include purchases of semi-finished goods or components)

Question 10

what is depreciation of capital

Answer 10

when capital loses value over time, this could be due to wear and tear, or because it becomes obsolete.

Question 11

Distinguish between investment and net investment

Answer 11

capital needs to be replaced or the value of capital stock in the economy will fall due to depreciation. net investment is investment over and above the amount of investment needed to replace depreciated capital. investment minus depreciation

Question 12

name 6 factors that would increase investment

Answer 12

• lower interest rates: reduces cost of loans so more investment projects will be viable
• high animal spirits: high confidence means businesses will want to increase production and if they are at full capacity they need to invest
• demand for exports rises: firms selling overseas need to increase output, if at full capacity they need to invest
• access to credit improves: After global financial crisis is 2008, business investment was mainly low due to the credit crunch, when it is easier for firms to access loans this facilitates investment.
• Lower corporation tax and business regulations: if corporation tax is low more profit, which is a source of investment, if regulations are loosened, money saved, profit up, more retained profit for investment
• a high rate of economic growth: indicator that firms need to produce more, if at full capacity, investment needed.

Question 13

Define government expenditure

Answer 13

In the context of AD: refers only to government purchasing of goods and services such as paying for nurses and doctors and purchasing drugs for use in hospitals. Can be referred to as current expenditure.

Question 14

distinguish between government spending and government expenditure

Answer 14

Spending= wider context, includes spending on transfer payments where there is nothing in return like pensions and welfare payments. also includes spending on investment projects like cross-rail and HS2 rail links. 
Expenditure= purchasing of goods and services like doctors and drugs for use in hospitals.

Question 15

define fiscal policy

Answer 15

fiscal policy is taxation and spending

Question 16

Name 3 fiscal policies

Answer 16

1 income tax falling, 2 VAT increasing, 3 Corporation tax falling

Question 17

what is meant by a budget deficit

Answer 17

when government spending is higher than tax revenue

Question 18

how does the trade cycle affect government spending

Answer 18

recession= higher spending as more people claim unemployment benefits etc, also government. often deliberately runs a deficit in order to stimulate the economy e.g. by spending on investment projects like infrastructure. Finally tax revenue from income tax, corporation tax, VAT etc. falls as there is less economic activity which leads to a deficit during a recession.

Question 19

define exports

Answer 19

currency flowing into the UK due to selling UK produced goods and services abroad

Question 20

define imports

Answer 20

currency flowing out of the UK into foreign countries due to purchases of goods and services produced abroad

Question 21

what is meant by net exports

Answer 21

X-M, the value of exports - the value of imports

Question 22

define exchange rate

Answer 22

the rate at which one currency can be exchanged for another

Question 23

explain the effect on the current account of a change in the Sterling exchange rate

Answer 23

Strong pound= cheap imports, expensive exports.
Weak pound= expensive imports, cheap exports.
SPICEE

Question 24

What is meant by the J curve effect

Answer 24

When the currency depreciates, and at first UK producers and consumers continue to buy imports. This is because they have a low PED for imports in the immediate term. This is because they may be locked into contracts and cannot change suppliers until this is renewed, or it might take time to change purchasing habits. In the short run a current account deficit would get worse however in time the current account would improve and turn into a surplus which can be seen on a diagram

Question 25

what is meant by the Marshall-Lerner condition

Answer 25

the Marshall-Lerner condition states that a current account deficit will improve following depreciation, but only if the sum of imports and exports >1

Question 26

how does domestic inflation affect net exports

Answer 26

Prices rise domestically, then UK exports look less competitive compared to similar goods produced by other countries so next exports would fall

Question 27

how does a global recession affect exports

Answer 27

like after 2008, the demand for UK exports would fall

Question 28

how does the domestic business cycle affect imports

Answer 28

during a UK recession, consumption of all goods and services including imports falls

Question 29

what is meant by protectionism + examples

Answer 29

Protectionism is when a country uses barriers of trade to protect domestic industry.
E.G. Tariffs (import tax), Quotas (limits on the number of goods that can be imported), Non-Tariff-Barriers (NTBs) - cover a multitude of other measures, such as ‘red tape’, health and safety requirements and domestic subsidies.

Question 30

What does the SRAS curve look like

Answer 30

positive straight line

Question 31

what is meant by the circular flow of income

Answer 31

shows how different sectors of the economy link together, for example how workers are employed by firms, and there is a money flow from the firm to the workers in wages, and a real flow the other way from workers to the firm in the form of labour supplied