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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.