Limitations of Circular Flow and Aggregate Demand

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Questions and Answers

What primary factor primarily drives the circular flow of income model?

Demand-side fluctuations (correct)

Government policies

Investment levels

Supply-side considerations

How does an increase in the general price level affect aggregate demand?

It has no impact on aggregate demand

It only affects a specific sector of the economy

It increases aggregate demand through higher investment

It decreases aggregate demand due to a fall in purchasing power (correct)

What effect does the erosion of financial wealth have on consumption?

It has no significant effect

It stimulates investment in financial markets

It depresses consumption as people withdraw savings (correct)

It encourages increased spending

What happens to the aggregate demand curve if consumers decide to spend more?

It shifts rightward Signup and view all the answers

Which of the following best describes the relationship modeled by the aggregate supply curve?

The willingness of firms to supply at various price levels Signup and view all the answers

What is a potential impact of rising interest rates in the context of aggregate demand?

Discourages borrowing and leads to lower aggregate demand Signup and view all the answers

Which effect suggests that higher prices lead to increased imports due to reduced domestic purchasing?

International substitution effect Signup and view all the answers

In the short run, what is the expected behavior of total supply as prices increase?

Total supply increases Signup and view all the answers

What happens to profit when output prices increase, assuming certain factors remain constant?

Profit increases because prices rise faster than costs. Signup and view all the answers

How may the marginal cost of additional output be affected by the existing levels of output?

Marginal costs may be higher at higher output levels. Signup and view all the answers

Which factor may cause prices of inputs to rise more slowly than prices of final goods and services?

Sticky prices and wages due to contracts. Signup and view all the answers

What is the consequence of a positive output gap when the AD curve shifts to the right?

The AS curve shifts left resulting in increased prices. Signup and view all the answers

What leads to a negative output gap when the AS curve shifts left?

Shortage of supply leading to decreased output. Signup and view all the answers

What conditions lead to the AS curve shifting when potential output rises?

Increase in quantity of factors of production. Signup and view all the answers

What best describes the situation when the supply has a lot of slack?

Prices may remain stable without significant change. Signup and view all the answers

Which of the following best represents the main challenge for firms and workers in predicting price level changes?

Sticky wages and menu costs. Signup and view all the answers

Study Notes

Limitations of the Circular Flow of Income Model

The model focuses on the demand side, but supply is equally important for firms' output
It doesn't account for firms' supply decisions
Changes in aggregate demand impact both output and prices

Aggregate Demand Curve

Examines the relationship between total demand for goods/services and average price levels
Uses GDP deflator to measure overall price levels, not just individual products
Aggregate demand decreases as prices increase

Income Effect

Real incomes decline when prices rise because wages often don't adjust as quickly
Reduced consumer spending leads to a decrease in aggregate demand
Potential offset by increased profits (leading to increased investment), but this is unlikely due to reduced demand. Increased dividend payments for shareholders may partially counteract.

Substitution Effect

Real balance effect (wealth effect): Erosion of financial wealth due to rising prices reduces consumption. Savings are worth less, so people withdraw more from savings accounts to maintain their savings' worth.
Inter-temporal substitution effect (interest effect): Higher prices lead to increased demand for money, resulting in higher interest rates, discouraging spending and encouraging saving. Investment decreases due to higher borrowing costs.
International substitution effect (net exports effect): Higher domestic prices make domestic goods less competitive internationally, leading to increased imports and reduced exports.

Shifts in Aggregate Demand

Positive demand shock (increase in consumer spending, investment etc) shifts the curve rightwards
Negative demand shock (decrease in consumer spending, investment etc) shifts the curve leftwards

Aggregate Supply Curve

Models the relationship between firms' output and the overall price level
Output increases as prices increase in the short run due to increased profit margins
Marginal costs may increase with higher output levels
Availability of factors of production (labour, resources) influences production capacity, affecting the steepness of the AS curve.
Diminishing returns affect aggregate output and costs more steeply at higher production levels
Price changes in final goods/services affect input prices like wages/resources. This can impact AS curve responsiveness to changes in price

Long-Run Aggregate Supply (LRAS)

Determined by factors like the labour force, capital stock, and technological advancements
Price levels do not affect LRAS in the long run
Shifts in LRAS are driven by changes in factors like technology, labour force, or capital investment. Short run supply is more responsive/reactive to changing conditions compared to LRAS.

Increase in Aggregate Supply

Scenario 1: Increasing supply at each price level up until full capacity, driven by factors like lower wages or input costs
Scenario 2: Potential output increases due to factors like increased production capacity, technological improvements, or more human capital.

Equilibrium

When aggregate demand (AD) shifts right, output increases and equilibrium moves towards a positive output gap and higher prices
When AD shifts left, output and employment fall; this results in a negative output gap and reduced prices.
When AS shifts left, there is reduced output and higher prices.

Keynesian Model Integration

Combining AS/AD and Keynesian models shows the impact of demand shifts on national income. Changes in aggregate demand lead to shifts in the 45° line and AS/AD diagrams

Unemployment and Inflation

Deflationary gap (excess capacity): Withdrawal exceed injections at full employment level of national income.
Inflationary gap (excess demand): Injections exceed withdrawals at full employment.

Other Points

Firms adjust prices and wages slowly due to menu costs (costs of changing prices) and wage rigidity.
Shifts in AS curves result from changes in available labour and capital.

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Description

Explore the limitations of the Circular Flow of Income model and its implications for aggregate demand and supply dynamics. Understand how changes in prices affect consumer spending and the overall economy, including the impact of the income and substitution effects.