The AD/AS Model (Themes 2 & 4)
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23 Terms
what is ad?
Expenditure = AD = C + I + G + X - M. AD represents the total demand for all goods and services produced in an economy at a given price level
what affects consumption?
wealth, disposable income, confidence (and expectations), taxes, interest rates and availability of credit
what is investment and how is it determined?
Investment is expenditure on capital. In other words expenditure on buildings, equipment, and machinery (tangible):
interest rates, consumption, corporate tax, capacity utilisation, labour prices and profit levels
what is fiscal policy?
This is the use of Government spending and taxation to control the economy
what are the problems with fiscal policy?
spending may be inefficient and there is a time lag effect
it is possible that deficits are run up, so there is debt
what determines exports and imports?
exchange rates, protectionism levels, income levels (both in the UK and abroad), desirability of products
what are supply side policies?
Micro economic measures taken by the Government to improve the efficiency of businesses and therefore increase a nation’s aggregate supply
what supply side policies could be enforced to improve labour?
tax cuts, immigration, deregulation (less job security), cutting union power, training and eductation
what supply side policies could be enforced to improve other factors of production?
tax cuts, loans, grants and subsidies to encourage investment and risk taking. encouraging better land usage (but this may be costly)
how does the government borrow?
gilts - sells bonds and repays over time.
treasury bills
premium bonds and national savings
what are problems with a budget deficit?
future generations will have to pay it back (but are they better off?)
may drive the value of the pound down
can cause inflation if government spends to much - depends on where AD and AS are and how close to full capacity we are
depends on how well money is spent and the state of the economy - in a recession it is more acceptable to have a deficit
what is monetary policy?
the use of interest rates and money supply to control the economy
what is the transmission mechanism?
if Bank of England puts rates down, banks should too
but banks may continue to charge higher rates to offset loss
and consumption does not necessarily increase due to confidence levels
how does quantitative easing work?
when AD goes down:
the bank purchases government bonds from sector businesses, which increases asset prices (wealth goes up)
cash is spent on assets that will give a return
yield falls
So there is more lending
what are the problems with using monetary policy?
interest rates: the transmission mechanism and investment
difficult to control banks and money supply. QE tends to favour those with more wealth (so contributes to inequality)
it affects the housing market and may have other unintended consequences - interest rates go up, mortgage rates increase too, so demand falls and with it house prices
ineffective if there is no confidence
what is an exchange rate?
the value of a currency in terms of what it can buy of other currencies
it is bilateral - if one goes up, the other has gone up
how is currency demand determined?
inflows of investment, hot money flows, interest rates, speculation
if any of these factors increase, demand increases
how is currency supply determined?
import, outflows of investment, foreign interest rates, speculative selling
what is the real effective exchange rate?
the weighted average of a country’s currency in relation to an index or basket of other major currencies
these weightings depend on how much trade occurs with them
what happens if the pound gets stronger?
AD shifts in - importers have happier than exporters
AS curve shifts down due to reduced costs
what are some macroeconomic benefits of joining the Euro?
Rapid extension of trade and competition within the EU
Lower inflation and long term interest rates (which improves AS)
Greater exchange rate stability
Membership of the Euro supports Foreign Investment inflows in the long term
what are some microeconomic benefits of joining the Euro?
Potential gains for consumers
Lower prices because of increased competition/greater price transparency
Reduction in the transactions costs of travelling within Europe (e.g. costs of currency exchange)
Benefits for business:
Invoicing can be done in just one currency
Lower transactions cost
Gains for the tourism industry
Business investment at lower interest rates
This will all reduce risk
what are some drawbacks to entering the Euro?
Loss of instruments of policy adjustment. Countries have different shaped AD and AS curves (but Growth and Stability Pact ensure they have similar economic environments)
Fiscal policy. Lack of ability to enforce budget deficit rules- Governments borrow and then can’t print money to repay