Theme 2: Part 2

What is aggregate demand (AD)?

"- Total planned expenditure in an economy

- At a given general price level

- Over a period of time"

What is the aggregate demand formula?

"- AD = C + I + G + X - M"

What does the aggregate demand curve show?

"- Relationship between real planned expenditure and price level

- Inverse relationship"

Why does the AD curve slope downwards?

"- Real income effect

- Interest rate effect

- Balance of trade effect"

What is the real income effect?

"- Fall in price level increases real income

- Consumers can buy more goods and services"

What is the interest rate effect?

"- Lower price level may reduce interest rates

- Borrowing increases and saving falls"

What is the balance of trade effect?

"- Lower domestic prices increase exports

- Imports become relatively more expensive"

What causes an extension of aggregate demand?

"- Fall in the general price level

- Movement along the AD curve"

What causes a contraction of aggregate demand?

"- Rise in the general price level

- Movement along the AD curve"

What causes a rightward shift of aggregate demand?

"- Increase in consumption

- Increase in investment

- Increase in government spending

- Increase in net exports"

What causes a leftward shift of aggregate demand?

"- Decrease in consumption

- Decrease in investment

- Decrease in government spending

- Decrease in net exports"

How does rising real income affect aggregate demand?

"- Increases consumption

- Raises confidence and job security

- Encourages investment"

How does consumer and business confidence affect AD?

"- Higher confidence increases C and I

- Lower confidence reduces C and I"

What is the wealth effect?

"- Rising asset prices increase perceived wealth

- Encourages higher consumption"

How does monetary policy affect aggregate demand?

"- Lower interest rates encourage borrowing

- Higher interest rates discourage spending"

How does fiscal policy affect aggregate demand?

"- Increased government spending raises AD

- Tax cuts increase consumption and investment"

How do exchange rates affect aggregate demand?

"- Depreciation increases exports

- Depreciation reduces imports

- Net exports rise"

What is short-run aggregate supply (SRAS)?

"- Total output firms are willing and able to supply

- At a given price level

- When some costs are fixed"

Why does the SRAS curve slope upwards?

"- As prices rise firms increase output

- Due to rising marginal costs"

What are the main determinants of SRAS?

"- Costs of production

- Indirect taxes and subsidies

- Exchange rates"

How do changes in wages affect SRAS?

"- Higher wages increase costs

- Shift SRAS left"

How do changes in commodity prices affect SRAS?

"- Higher raw material prices increase costs

- Shift SRAS left"

How do indirect taxes affect SRAS?

"- Increase production costs

- Shift SRAS left"

How do subsidies affect SRAS?

"- Lower production costs

- Shift SRAS right"

How do exchange rates affect SRAS?

"- Depreciation raises import costs

- Appreciation lowers import costs"

What causes a leftward shift of SRAS?

"- Increase in costs

- Higher taxes

- Rising import prices"

What causes a rightward shift of SRAS?

"- Fall in costs

- Lower taxes

- Subsidies"

What is the neo-classical view of SRAS?

"- SRAS becomes vertical at full employment

- Labour market clears in long run"

What is long-run aggregate supply (LRAS)?

"- Maximum sustainable output of an economy

- Output when all resources are fully employed"

What determines long-run aggregate supply?

"- Quantity and quality of labour

- Capital stock

- Technology

- Institutional framework"

What is the neo-classical view of LRAS?

"- Vertical LRAS at full employment

- Economy returns to potential output"

What is the Keynesian view of LRAS?

"- LRAS has elastic and inelastic sections

- Spare capacity exists below full employment"

How does investment affect LRAS?

"- Increases capital stock

- Improves productivity"

How does education and training affect LRAS?

"- Improves human capital

- Increases labour productivity"

How does technological progress affect LRAS?

"- Increases efficiency

- Enables higher output"

How do supply-side policies affect LRAS?

"- Shift LRAS to the right

- Increase productive capacity"

How is economic growth shown on an AD/AS diagram?

"- Rightward shift of LRAS

- Increase in potential output"

What is macroeconomic equilibrium?

"- Point where aggregate demand equals aggregate supply

- Determines price level and real output"

What is short-run macroeconomic equilibrium?

"- AD intersects SRAS

- Output may differ from potential output"

What is long-run macroeconomic equilibrium?

"- AD intersects LRAS

- Economy operating at full employment"

What is an inflationary gap?

"- Actual output exceeds potential output

- Excess demand causes inflationary pressure"

What is a deflationary gap?

"- Actual output below potential output

- Spare capacity in the economy"

How can an inflationary gap be corrected?

"- Contractionary fiscal policy

- Tighter monetary policy"

How can a deflationary gap be corrected?

"- Expansionary fiscal policy

- Looser monetary policy"

What is a demand-side shock?

"- Sudden change in aggregate demand

- Can be positive or negative"

Give examples of positive demand-side shocks

"- Increase in consumer confidence

- Expansionary fiscal policy"

Give examples of negative demand-side shocks

"- Fall in exports

- Financial crisis"

What is a supply-side shock?

"- Sudden change in aggregate supply

- Affects costs or productive capacity"

Give examples of negative supply-side shocks

"- Oil price rise

- Natural disasters"

Give examples of positive supply-side shocks

"- Technological breakthroughs

- Reduction in regulation"

How do negative supply-side shocks affect the economy?

"- Higher inflation

- Lower output

- Higher unemployment"

What is stagflation?

"- High inflation

- Low or negative economic growth

- High unemployment"

What is the Phillips curve?

"- Shows relationship between inflation and unemployment

- Inverse relationship in the short run"

What does the short-run Phillips curve show?

"- Trade-off between inflation and unemployment

- Based on expectations remaining constant"

Why does a trade-off exist in the short run?

"- Higher AD reduces unemployment

- Increases inflationary pressure"

What causes a movement along the short-run Phillips curve?

"- Changes in aggregate demand

- Demand-side policies"

What causes a shift in the short-run Phillips curve?

"- Changes in inflation expectations

- Supply-side shocks"

What is the long-run Phillips curve?

"- Vertical at the natural rate of unemployment

- No trade-off in the long run"

What is the natural rate of unemployment?

"- Level of unemployment when labour market clears

- Includes frictional and structural unemployment"

Why is the long-run Phillips curve vertical?

"- Inflation expectations adjust

- Economy returns to natural rate of unemployment"

What are adaptive expectations?

"- Expectations based on past inflation

- Adjust slowly over time"

What are rational expectations?

"- Expectations based on all available information

- Adjust quickly to policy changes"

How do inflation expectations affect unemployment?

"- Higher expected inflation shifts SRPC right

- No long-run reduction in unemployment"

What is the role of supply-side policies in the Phillips curve?

"- Reduce natural rate of unemployment

- Shift long-run Phillips curve left"

What caused the breakdown of the Phillips curve in the 1970s?

"- Oil price shocks

- Rising inflation and unemployment"

What is the policy implication of the Phillips curve?

"- Demand-side policies have short-run effects

- Supply-side policies needed for long-ter

How can fiscal policy be used to manage aggregate demand?

"- Increase government spending

- Cut taxes to boost AD

- Reduce spending or raise taxes to reduce AD"

How can monetary policy be used to manage aggregate demand?

"- Adjust interest rates

- Use quantitative easing

- Use forward guidance"

How can supply-side policies be used to manage inflation?

"- Increase productive capacity

- Reduce cost pressures

- Shift LRAS to the right"

How can inflation be controlled using AD/AS analysis?

"- Shift AD left using contractionary policy

- Increase AS through supply-side measures"

How can unemployment be reduced using AD/AS analysis?

"- Shift AD right using expansionary policy

- Shift LRAS right using supply-side policies"

What policy response is appropriate for a deflationary gap?

"- Expansionary fiscal policy

- Expansionary monetary policy"

What policy response is appropriate for an inflationary gap?

"- Contractionary fiscal policy

- Tighter monetary policy"

What is policy conflict?

"- When one policy objective undermines another

- Trade-offs between objectives"

Give an example of policy conflict

"- Reducing unemployment may increase inflation

- Reducing inflation may increase unemployment"

What is policy coordination?

"- Use of multiple policies together

- Aims to reduce policy conflict"

Why is policy coordination important?

"- Improves effectiveness

- Minimises unintended consequences"

What are time lags in macroeconomic policy?

"- Delay between policy decision and impact

- Reduces effectiveness"

What is a recognition lag?

"- Delay in identifying an economic problem

- Data may be outdated"

What is an implementation lag?

"- Delay in putting policy into action

- Common with fiscal policy"

What is an impact lag?

"- Delay before policy affects the economy

- Common with monetary policy"

What are the limits of demand-side policies?

"- Risk of inflation

- Time lags

- Public debt concerns"

Why are supply-side policies important in the long run?

"- Increase potential output

- Reduce inflationary pressure

- Improve competitiveness"

What are the main macroeconomic objectives?

"- Economic growth

- Low inflation

- Low unemployment

- Balance of payments stability"

Why is evaluation important in macroeconomic policy?

"- Assess effectiveness

- Identify trade-offs

- Improve future decisions"