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Workshop 7: Aggregate Demand and Supply and Macroeconomic Problems

  1. Position each of the following eight terms in the UK's circular flow of income diagram below:

    Consumption (of domestically produced goods and services); Net saving; Net taxation; Government expenditure; Factor payments (national income); Expenditure on imports; Investment; Expenditure on exports.

    Economists use specific letters to label each of these terms. The letters used are:

    S, G, X, M, I, Cd, T, Y

    Add the correct letter to each of the terms you have written on the diagram.

    Circular Flow of Income Diagram

  2. Which of the following are changes in injections into, and which are changes in withdrawals from the UK's circular flow of income? In each case, identify whether the change is an increase or a decrease. In each case, assume that this is the only change. (Delete wrong words.)
    1. A council funds the building of new libraries. Withdrawal/Injection. Increase/Decrease
    2. The government raises tax-free thresholds. Withdrawal/Injection. Increase/Decrease
    3. The government reduces child benefit. Withdrawal/Injection. Increase/Decrease
    4. Fewer tourists visit the UK. Withdrawal/Injection. Increase/Decrease
    5. Firms, anticipating a rise in consumer demand, borrow more money in order to build up their stocks. Withdrawal/Injection. Increase/Decrease
    6. Consumers demand more goods that are domestically produced (but total consumption does not change). Withdrawal/Injection. Increase/Decrease
    7. People invest more money in banks and building societies. Withdrawal/Injection. Increase/Decrease

  3. What will happen to the level of the UK's national income if the following changes occur? (In each case, assume other things remain unchanged.)
    1. Firms are encouraged by lower interest rates to build new factories. Rise / Fall / Impossible to tell without more information
    2. Consumers abroad are deterred by a high price for the pound from buying imports from the UK. Rise / Fall / Impossible to tell without more information
    3. Both taxation and government expenditure are reduced. Rise / Fall / Impossible to tell without more information
    4. People decide to save a larger proportion of their income. Rise / Fall / Impossible to tell without more information
    5. Our trading partners overseas begin to recover from recession. Rise / Fall / Impossible to tell without more information

  4. What would be the effect of each of the following events on actual and potential economic growth? (Assume no other changes take place.)
    1. A reduction in the level of investment. Actual growth: rise / fall / no effect. Potential growth: rise / fall / no effect.
    2. People save a larger proportion of their income. Actual growth: rise / fall / no effect. Potential growth: rise / fall / no effect.
    3. A reduction in the working week. Actual growth: rise / fall / no effect. Potential growth: rise / fall / no effect.
    4. Increased expenditure on education and training. Actual growth: rise / fall / no effect. Potential growth: rise / fall / no effect.
    5. The discovery of new more efficient techniques which could benefit industry generally. Actual growth: rise / fall / no effect. Potential growth: rise / fall / no effect.
    6. A reduction in interest rates. Actual growth: rise / fall / no effect. Potential growth: rise / fall / no effect.

  5. Given the following possible types of unemployment - demand-deficient, real-wage (wage push), frictional, structural, regional, technological and seasonal - which one is likely to worsen in each of the following cases?
    1. The introduction of robots in manufacturing

    2. The economy moves into recession

    3. Legislation is passed guaranteeing everyone a minimum wage that is 80% of the national average

    4. The government decides to close job centres in an attempt to save money

    5. The Bank of England raises interest rates


  6. The following diagram shows an aggregate demand curve and an aggregate supply curve.

    An aggregate demand curve and an aggregate supply curve
    1. Label the two axes.
    2. Give three reasons why the AD curve is downward sloping.



    3. Why is the AS curve upward sloping (at least in the short run)?


    4. Give two things that could shift the AD curve to the right.


    5. Give two things that could shift the AS curve to the right.



  7. The following table shows the harmonised index of consumer prices (HICP) for the UK, where 1996 = 100.0. Calculate the rate of inflation for the eight years 1995-2002. The formula is:
    Inflation =((Pt - Pt-1) / Pt-1) x 100

    where t is the year in question and t-1 is the previous year. Give your answer to one decimal place. (The figure for 1994 is given and is based on an index of 93.2 for 1993.)

    Year 1994 1995 1996 1997 1998 1999 2000 2001 2002
    Price index 95.1 97.6 100.0 101.8 103.4 104.8 105.6 106.9 108.3
    Rate of inflation 2.0                


  8. Will the following lead to cost-push or demand-pull inflation, or both?

    1. The Bank of England cuts interest rates and the economy booms. Cost-push / Demand-pull / Both
    2. As a result of falling unemployment, trade unions become more militant and demand higher wages. Cost-push / Demand-pull / Both
    3. The government raises the rate of VAT. Cost-push / Demand-pull / Both
    4. The government cuts income tax rates and raises government expenditure at a time of near full employment. Cost-push / Demand-pull / Both
    5. Increasing industrial concentration leads to more oligopolistic collusion to raise prices. Cost-push / Demand-pull / Both

  9. The following table gives the aggregate demand and aggregate supply schedules in February 2005 for a particular country. (Ignore the AD2 and AS2 columns until question d. below and AD3 until question h.)

    Price level Aggregate demand (£ billions) AD2 AD3 Aggregate supply (£ billions) AS2
    951000  950 
    100970  970 
    105950  1000 
    110930  1030 
    115915  1060 
    120900  1100 

    1. Draw the aggregate demand and aggregate supply curves on the following diagram, labelling them AD1 and AS1.
      An aggregate demand curve and an aggregate supply curve
    2. What is the equilibrium level of national income?
    3. What is the equilibrium price level?

    Assume that over the next 12 months aggregate demand rises by £70 billion at all price levels and that aggregate supply rises by £20 billion at all price levels.

    1. Enter the new figures for aggregate demand and aggregate supply on the table in the columns AD2 and AS2.
    2. Draw the new aggregate demand and supply curves on the diagram, labelling them AD2 and AS2.
    3. What is the new equilibrium level of national income in February 2006?
    4. What is the rate of inflation in February 2006?

    Assume that over the following 12 months aggregate demand rises by a further £50 billion at all price levels but that there is no increase in aggregate supply beyond AS2.

    1. Enter the new figures for aggregate demand on the table in the column AD3.
    2. Draw the new aggregate demand curve on the diagram, labelling it AD3.
    3. What is the new equilibrium level of national income in February 2006?
    4. What is the annual rate of inflation in February 2006 (clue: use the formula in question 7 of this workshop)?