3.2 Variations in Economic Activity (AD & AS) (DP IB Economics: HL): Flashcards
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Define aggregate demand (AD).
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Define aggregate demand (AD).
Aggregate demand (AD) is the total demand for all goods and services in an economy at a given average price level.
Using the expenditure approach, aggregate demand equals consumption plus investment plus plus net exports.
Using the expenditure approach, aggregate demand equals consumption plus investment plus government spending plus net exports.
Define consumption.
Consumption is the total spending on goods and services by consumers (households) in an economy.
What are net exports?
Net exports are the difference between the revenue gained from selling goods and services abroad and the expenditure on goods and services from abroad (X − M).
True or False?
Government spending within aggregate demand includes transfer payments.
False.
Government spending within aggregate demand covers items such as public sector salaries and merit/public goods, but it does not include transfer payments.
Define investment.
Investment is the total spending on capital goods by firms.
Why does a 1% rise in consumption raise UK growth more than a 1% rise in net exports?
Because consumption is roughly 60% of UK AD while net exports are only about 1%, so the same percentage change in consumption has a far larger impact on aggregate demand.
Why is the aggregate demand curve downward sloping?
Because a lower average price level is associated with greater aggregate demand, while a higher average price level is associated with less aggregate demand.
True or False?
A change in the average price level shifts the entire aggregate demand curve.
False.
A change in the average price level causes a movement along the AD curve (a contraction or expansion), not a shift of the whole curve.
What causes a shift of the entire aggregate demand curve?
A change in any non-price determinant of AD shifts the entire curve right (an increase) or left (a decrease).
How does a depreciation of the domestic currency affect net exports?
A depreciation raises net exports, because exports become less expensive for foreigners while imports become more expensive.
How does a rise in interest rates affect consumption?
A rise in interest rates reduces consumption, because it increases the incentive to save and raises the monthly repayments on loans and mortgages.
income is the money households have left from their wages after paying taxes and receiving any transfer payments.
Disposable income is the money households have left from their wages after paying taxes and receiving any transfer payments.
Define aggregate supply.
Aggregate supply is the total supply of goods and services produced within an economy at a specific price level at a given time.
Define the short run in macroeconomics.
The short run is a period in which wages and other factor prices are inflexible.
Why is the short-run aggregate supply curve upward sloping?
Because as real output increases, firms face higher production costs (such as rising wage bills), which results in higher average prices.
Define the long run in macroeconomics.
The long run is a period in which there is full wage and factor price flexibility.
True or False?
A change in the average price level shifts the entire SRAS curve.
False.
A change in the average price level causes a movement along the SRAS curve (a contraction or expansion of output), not a shift of the whole curve.
Along the SRAS curve, what happens to real GDP when the average price level rises?
There is an expansion of real GDP, as the quantity supplied increases in response to the higher average price level.
What causes a shift of the entire SRAS curve?
A change in a non-price determinant of supply, such as the costs of production or productivity, shifts the entire SRAS curve.
In which direction does the SRAS curve shift if production costs fall?
The SRAS curve shifts right (SRAS increases), so at every price level output and real GDP are higher.
What are the two main non-price determinants of SRAS?
The two main non-price determinants are changes in the costs of raw materials and energy and changes in indirect taxes.
How does an increase in indirect taxes affect SRAS?
It decreases SRAS (shifts it left), because indirect taxes raise firms' costs and reduce output.
A rise in the price of raw materials and energy causes the SRAS curve to shift to the .
A rise in the price of raw materials and energy causes the SRAS curve to shift to the left.
True or False?
A decrease in indirect taxes shifts the SRAS curve to the left.
False.
A decrease in indirect taxes lowers firms' costs and raises output, shifting the SRAS curve to the right.
According to the Monetarist/New Classical view, what shape is the LRAS curve?
It is perfectly inelastic (vertical) at the full employment level of output (Y₀ₑ), which corresponds to the maximum output on the PPC.
In the Classical view, what happens in the long run after a fall in AD?
The economy self-corrects back to the full employment level of output (Y₀ₑ), with only the average price level ending up lower.
Define an output gap.
An output gap is the difference between the actual level of output (real GDP) and the maximum potential level of output.
Define an inflationary output gap.
An inflationary output gap occurs when real GDP is greater than potential real GDP.
Define a deflationary (recessionary) output gap.
A deflationary (recessionary) output gap occurs when real GDP is less than potential real GDP, leaving spare capacity in the economy.
Describe the shape of the Keynesian AS curve.
It is L-shaped with three sections: a perfectly elastic section at low output, an upward-sloping section as firms bid for resources, and a perfectly inelastic (vertical) section at full employment (Y₀ₑ).
In the Keynesian view, why can prices not fall in the elastic section of AS?
Because of downward wage rigidity caused by minimum wage laws, trade unions, and long-term employment contracts that prevent wages from falling.
True or False?
In the Keynesian view, an economy always self-corrects to the full employment level of output.
False.
Keynesians argue an economy may get stuck in equilibrium below full employment for a long period, as in the Great Depression.
What policy response does the Keynesian view advocate when output is stuck below full employment?
The government should increase its expenditure to shift AD and restore confidence (animal spirits) in the economy.
A deflationary output gap occurs when real GDP is than potential real GDP.
A deflationary output gap occurs when real GDP is less than potential real GDP.
True or False?
An inflationary output gap is the same as inflation.
False.
Output gaps focus on output, not price levels; an inflationary output gap means the economy is producing beyond its full employment level of output.
What might rising unemployment and a slowdown in growth indicate about output gaps?
They can indicate that a negative (deflationary) output gap is increasing.
Define an efficiency improvement as a determinant of LRAS.
An efficiency improvement is process innovation that raises productivity, such as moving from labour-intensive to automated car production.
What does a rightward shift of the LRAS curve represent?
It represents an increase in the potential (maximum) output of the economy, corresponding to an outward shift of the PPC.
What are the four factors that shift the LRAS curve?
Changes in the quality or quantity of the factors of production, technological advances, efficiency improvements, and changes in institutions.
Define a technological advance as a determinant of LRAS.
A technological advance often improves the quality of the factors of production (for example, the development of new metal alloys), increasing potential output.
How can a change in migration policy shift the LRAS?
It can increase the quantity of labour, a factor of production, which raises the economy's potential output and shifts LRAS right.
How can changes in institutions increase the LRAS?
More financial institutions raise access to finance, and new legislation such as competition policy makes market entry easier, both increasing potential supply.
True or False?
A change to short-run aggregate supply (SRAS) changes the potential output of the economy.
False.
Only shifts of the LRAS change potential output; changes to SRAS do not alter the economy's productive potential.
A rightward shift of the LRAS curve corresponds to an shift of the production possibilities curve.
A rightward shift of the LRAS curve corresponds to an outward shift of the production possibilities curve.
In the Classical model, what happens to the average price level when the LRAS increases?
The extra supply allows the average price level to fall while output increases, giving a new equilibrium at a higher potential output.
How can improving workers' education shift the LRAS?
Better education increases the quality of labour, shifting the LRAS to the right and raising the economy's potential output.
True or False?
An increase in the quality of the factors of production shifts the LRAS to the left.
False.
An increase in the quality of the factors of production shifts the LRAS to the right, raising potential output.
In the Keynesian model, how does an increase in the quantity of labour affect the AS curve?
It shifts the AS curve to the right, increasing the economy's possible level of output.
Define real national output equilibrium.
Real national output equilibrium occurs where aggregate demand (AD) intersects short-run aggregate supply (SRAS).
In the Classical model, where does long-run equilibrium occur?
At the intersection of AD, SRAS and LRAS, which is the full employment level of output (Y₀ₑ).
In the Classical model, the full employment level of output (Y₀ₑ) is considered equal to the rate of unemployment.
In the Classical model, the full employment level of output (Y₀ₑ) is considered equal to the natural rate of unemployment.
In the Classical adjustment from a deflationary gap, how does SRAS shift back to Y₀ₑ?
Unemployed workers accept lower wages, which reduces production costs and shifts SRAS right, returning output to Y₀ₑ at a lower average price level.
In the Classical adjustment from an inflationary gap, how does SRAS shift back to Y₀ₑ?
Workers demand higher wages, which raises production costs and shifts SRAS left, returning output to Y₀ₑ at a higher average price level.
Define the self-correcting mechanism.
The self-correcting mechanism is the Classical process by which an economy automatically returns to full employment output in the long run, with only the average price level changing.
True or False?
In the Classical model, government intervention is required to return the economy to full employment output.
False.
The Classical model relies on the self-correcting mechanism: flexible wages and prices automatically restore Y₀ₑ without government intervention.
In the Keynesian model, at what level of output can long-run equilibrium occur?
At any level of output, including one stuck well below the full employment level, as in the Great Depression.
Why might wages be 'sticky downwards' in the Keynesian model?
Because minimum wage laws, trade unions, and long-term employment contracts prevent wages from falling further.
Define animal spirits.
Animal spirits are the human emotions that drive financial decisions during times of uncertainty or market volatility.
True or False?
Classical economists assume that wages are flexible.
True.
Classical thinking assumes wages can easily rise or fall to change costs of production, allowing markets to self-correct to Y₀ₑ.
Which type of policy do Classical economists favour for generating economic growth?
Supply-side policies, which increase the productive capacity of the economy, following Say's Law.
What does the Keynesian phrase 'in the long-run we are all dead' imply?
That relying on markets to self-correct in the long run is flawed, because the long run can be a very long period during which severe recessionary gaps cause lasting harm.
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