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Short Answer Questions: Chapter 9
Q1. Explain what a business cycle is.
Q2. Briefly explain the meaning of the four key macroeconomic outputs.
Q3. Discuss the circular flow of income.
Q4. Explain the concepts of leakage from and injection into the circular flow and provide
one example for each.
Q5. What is total expenditure?
Essay questions
E1. Explain what the aggregate demand curve is and how it can be combined to
aggregate supply to describe the macroeconomic equilibrium of a country.
E2. Discuss why what matters for aggregate supply are real changes in relative prices and
wages, and not nominal.
ANSWERS:
Short Answer Questions
Q1. Explain what a business cycle is.
A: A business cycle is a period of activity where, over time, an economy can grow at
a faster rate, a so-called ‘economic boom’, and then move into a period of slower
growth, an economic recession.
Q2. Briefly explain the meaning of the four key macroeconomic outputs.
A. The four key macroeconomic outputs are Gross Domestic Product, inflation,
unemployment, and the current account. GDP, gross domestic product, is a
measure of the total output produced by an economy in a given year. Inflation is the
rate of change in the average price level. Inflation of 2 per cent indicates that prices
have risen by 2 per cent during the previous 12 months. Unemployment is the
number of individuals seeking work, but that do not currently have a job. The
current account is the difference between exported and imported goods and
services.
Q3. Discuss the circular flow of income.
A. The circular flow of income shows the flow of inputs, output and payments
between households and firms within an economy. The circular flow of income
captures the essential essence of macroeconomic activity. The economy is seen as
nothing more than a revolving flow of goods, production resources and financial
payments. The faster the flow, the higher the level of economic output.
Q4. Explain the concepts of leakage from and injection into the circular flow and provide
one example for each.
A. A leakage from the circular flow is income not spent on goods and services
within the economy. Leakages can be savings, taxation and imports. An injection
into the circular flow is additional spending on goods and services that does not
come from the income earned by households in the inner loop. Injections can be
investment, government spending and exports. Savings and investments are two
examples of leakage and injection, respectively. Rather than spend all income on
goods and services, households could save a proportion of their income. Because
income is being taken from the circular flow of income and saved, it represents a
leakage. But an important question relates to where these savings go. If the money
is placed on deposit at the bank, then the bank will try to lend the money for profit.
Borrowers are likely to be firms seeking to invest in equipment, or needing to fund
overdrafts. If firms invest in capital equipment, then they are buying goods and
services from other firms. As a result, investment is spending in the economy that
does not come from the income earned by households. As such, investments
represent an injection of financial resource and spending, by firms, into the circular
flow. In equilibrium, savings will equal investments. This is because banks will set
an interest rate where the supply of funds from savers equals the demand for funds
by investing firms.
Q5. What is total expenditure?
A. Total expenditure is simply all the separate sources of spending within the
economy. That is, consumption by households, investment by firms and public
spending by government. Net exports adjusts for expenditure on exports and
imports by consumers, firms and government. Being able to identify the individual
components of total expenditure is particularly important because it provides an
understanding of which expenditures lead to an increase (or decrease) in economic
activity. If consumption, investment, government spending, or net exports increase,
then total expenditure increases, and potentially the flow of goods and services in
the inner loop also increases to match the increased demand in the economy.
Similarly, if total expenditure is reduced, the flow of goods and services in the inner
loop falls due to decreasing demand. We will now use these ideas to develop our
understanding of changes in economic activity over time and the idea of a
macroeconomic equilibrium.
Essay questions
E1. Explain what the aggregate demand curve is and how it can be combined to
aggregate supply to describe the macroeconomic equilibrium of a country.
Answer guidelines. You need to start from the observation that aggregate demand
(AD) represents total demand in the economy. AD = C + I + G + NX, where C =
consumption, I = investment, G = government spending, and NX = net exports. You
then plot it on a graph with inflation on the vertical axis and output on the horizontal
axis, showing that the relationship between output and inflation is negative. You
then plot the supply curve into the same graph, i.e. a line with a positive slope, and
explain that the equilibrium requires AD=AS.
E2. Discuss why what matters for aggregate supply are real changes in relative prices and
wages, and not nominal.
Answer guidelines. What you should highlight here is that if inflation leads to a k
per cent increase in prices for final products and workers also ask for a k per cent
pay rise to compensate for the rise in prices, then the real wage and the real price of
goods and services has stayed the same. Because real prices and wages are the
same, the real costs and revenues faced by the firm have not changed. Aggregate
supply will therefore remain unchanged as firms are faced with no reason to
increase (or decrease) their willingness to supply. We can, therefore, argue that
when wages fully adjust to inflation, aggregate supply remains constant.