3.2: Variations in Economic Activity

What is aggregate demand (AD)?

Total quantity of output all buyers in an economy want to buy at different possible price levels over a time period.

Why is the aggregate demand curve downward sloping?

Negative relationship between real GDP and price level.

What does aggregate demand consist of?

- Demand by consumers.

- Demand by firms.

- Demand by government.

- Demand by foreigners for exports minus demand for imports.

What causes movements along the AD curve?

Change in price level.

What causes a shift of the AD curve?

Change in determinants of AD (components of AD).

What are the determinants of AD? (4)

- Changes in consumer spending.

- Changes in investment spending.

- Changes in government spending.

- Changes in net export expending.

What causes changes in consumer spending? (6)

- Change in consumer confidence.

- Change in interest rates.

- Change in wealth.

- Change in income taxes.

- Change in level of household indebtedness.

- Future price level expectations.

How does increased consumer confidence impact aggregate demand?

Increases consumer spending, AD increases.

How does decreased consumer confidence impact aggregate demand?

Decreases consumer spending, AD decreases.

How do increased interest rates impact aggregate demand?

Borrowing more expensive, saving more attractive; decreased consumer spending; AD decreases.

How do decreased interest rates impact aggregate demand?

Borrowing is cheaper, saving less attractive; increased consumer spending; AD increases.

How does increased wealth impact aggregate demand?

Increases consumer spending; AD increases.

How does decreased wealth impact aggregate demand?

Decreases consumer spending; AD decreases.

How do increased income taxes impact aggregate demand?

Less disposable income, decreases consumer spending, AD decreases.

How do decreased income taxes impact aggregate demand?

More disposable income, increases consumer spending, AD increases.

How does increased household indebtedness impact aggregate demand?

Decreases consumer spending; AD decreases.

How does decreased household indebtedness impact aggregate demand?

Increases consumer spending; AD increases.

How does the expectation that prices will decrease impact aggregate demand?

Avoid spending now and wait for prices to fall; decreases consumer spending; AD decreases.

How does the expectation that prices will increase impact aggregate demand?

Buy now to avoid higher prices; increases consumer spending; AD increases.

What causes changes in investment spending? (6)

- Change in business confidence.

- Change in interest rates.

- Change in technology.

- Changes in business taxes.

- Change in level of corporate indebtedness.

- Legal/institutional changes.

How does increased business confidence impact aggregate demand?

Increases investment spending; AD increases.

How does decreased business confidence impact aggregate demand?

Decreases investment spending; AD decreases.

How does increased interest rates impact aggregate demand?

Borrowing is expensive; more attractive to save; decreases investment spending; AD decreases.

How does decreased interest rates impact aggregate demand?

Borrowing is cheaper; less attractive to save; increases investment spending; AD increases.

How does improvement technology impact aggregate demand?

Increases investment spending; AD increases.

How does increased taxes impact aggregate demand?

Less after-tax profit; decreases investment spending; AD decreases.

How does decreased taxes impact aggregate demand?

More after-tax profit; increases investment spending; AD increases.

How does increased corporate indebtedness impact aggregate demand?

Decreases investment spending; AD decreases.

How does decreased corporate indebtedness impact aggregate demand?

Increases investment spending; AD increases.

How do legal/institution changes that increase access to credit and property rights impact aggregate demand?

Increases investment spending; AD increases.

How do legal/institution changes that decrease access to credit and property rights impact aggregate demand?

Decreases investment spending; AD decreases.

How does increased government spending impact aggregate demand?

AD increases.

How does decreased government spending impact aggregate demand?

AD decreases.

What causes changes in government spending? (2)

- Changes in political priorities.

- Changes in economic priorities.

What causes changes in net export spending? (2)

- Change in national income abroad.

- Change in exchange rates.

- Change in level of trade protection.

How does increased national income abroad impact aggregate demand?

Foreign country with increased income will import more; domestic exports increase; increases net exports; AD increases.

How does decreased national income abroad impact aggregate demand?

Foreign countries with decreased income will import less; domestic exports decrease; decreases net export; AD decreases.

How does appreciation of the domestic currency impact aggregate demand?

Exports more expensive for other countries; domestic exports decreases; decreases net exports; AD decreases.

How does depreciation of the domestic currency impact aggregate demand?

Exports cheaper for other countries; domestic exports increase; increases net exports; AD increases.

How does free trade impact aggregate demand?

Depends on what is greater; increase in exports or increase in imports.

What is aggregate supply (AS)?

Total quantity of goods and service produced in an economy at different price levels over a time period.

What is short-run aggregate supply (SRAS)?

Relationship between price level and real GDP.

Why is the SRAS curve upward sloping?

Positive relationship between price level and real GDP supplied.

What causes a movement along the SRAS curve?

A change in price level.

What causes a shift of the SRAS curve?

A change in a determinant of SRAS.

What are the determinants of SRAS? (4)

- Change in wages.

- Change in non-labour resource prices.

- Changes in subsidies offered to businesses.

- Supply shocks.

How do increased wages impact aggregate supply?

Production costs increase; less profit; produce less; SRAS decreases.

How do decreased wages impact aggregate supply?

Production costs decrease; more profit; produce more; SRAS increases.

How do increased subsidies impact aggregate supply?

Production costs decrease; more profit; produce more; SRAS increases.

How do decreased subsidies impact aggregate supply?

Production costs increase; less profit; produce less; SRAS decreases.

How do harmful shocks impact aggregate supply?

Production costs increase; less profit; produce less; SRAS decreases.

How do beneficial shocks impact aggregate supply?

Production costs decrease; more profit; produce more; SRAS increases.

How do increases in non-labour resources prices impact aggregate supply?

Production costs increase; less profit; produce less; SRAS decreases.

How do decreases in non-labour resources prices impact aggregate supply?

Production costs decrease; more profit; produce more; SRAS increases.

Where is short-run equilibrium achieved?

At the intersection of AD and SRAS curves.

What happens if AD increases? (4)

- AD curve shifts right.

- Price level increases.

- Real GDP increases.

- Increased employment.

What happens if AD decreases? (4)

- AD curve shifts left.

- Price level decreases.

- Real GDP decreases.

- Increased unemployment.

What happens if SRAS increases? (4)

- SRAS curve shifts right.

- Price level decreases.

- Real GDP increases.

- Increased employment.

What happens if SRAS decreases? (4)

- SRAS curve shifts left.

- Price level increases.

- Real GDP decreases.

- Increased unemployment.

What is a recessionary gap?

When potential GDP > real GDP.

What is an inflationary gap?

When real GDP > potential GDP.

What is long run aggregate supply?

Relationship between price level and real GDP in the long run.

When is economy in long-run equilibrium?

When intersection of AD-SRAS is on LRAS curve.

What does the monetarist model suggest? (3)

- Wages and resource prices are fully flexible.

- Increase of AD always increase price level.

- Economy in deflationary gap automatically corrects.

What does the Keynesian model suggest? (3)

- Wages and resources prices are not flexible.

- Increase of AD does not always increase price level.

- Economy can remain in a deflationary gap.

What happens in the first (horizontal) section of the Keynesian model if AD increases?

- Increases real GDP.

- Price level is constant.

What happens in the second (curved) section of the Keynesian model if AD increases?

- Increases real GDP.

- Price level increases.

What happens in the third (vertical) section of the Keynesian model if AD increases?

- Real GDP constant.

- Price level increases rapidly.

What is represented when SRAS or the Keynesian AS shift right?

Positive economic growth.

What is represented when SRAS or the Keynesian AS shift left?

Negative economic growth.

What can cause a rightwards shift of LRAS / Keynesian AS? (6)

- Increase in the quantity of factors of production.

- Increase in the quality of factors of production.

- Improvements in technology.

- Increases in efficiency.

- Institutional changes.

- Reduction in natural rate of unemployment.