Variations in economic activity: aggregate demand and aggregate supply: notes and practice questions
- This topic explains how aggregate demand (AD) and aggregate supply (AS) interact to determine macroeconomic equilibrium and variations in economic activity.
- Aggregate demand is the total spending in an economy: .
- Shifts in the AD curve are caused by changes in its components' determinants, such as consumer confidence or interest rates.
- The short-run aggregate supply (SRAS) curve shifts due to changes in costs of factors of production or indirect taxes.
- Macroeconomic equilibrium occurs where AD intersects AS, determining real output and the price level.
- Economies can experience inflationary or deflationary/recessionary gaps.
- The long-run aggregate supply (LRAS) curve represents potential output at the natural rate of unemployment.
How it is examined
The workhorse diagram of Unit 3 and probably the most-drawn diagram in the exam after demand and supply. May 2025 Paper 2 TZ1 Q1(e) asked for an AD/AS diagram showing the effect of improved education on the full employment level of output for 4 marks, and the mark scheme accepted an LRAS-only diagram with no AD or SRAS drawn. SL Paper 1 TZ1 Q2(a) asked why, according to the Keynesian model, a country may experience a persistent deflationary gap, for 10 marks.
- Aggregate demand and the aggregate demand curve. (AO2, AO4)
- The components of AD: consumption plus investment plus government spending plus net exports, where net exports is total exports minus total imports. (AO2)
- The determinants of each AD component. (AO2) - C: consumer confidence, interest rates, wealth, income taxes, level of household indebtedness, expectations of the future price level. - I: interest rates, business confidence, technology, business taxes, level of corporate indebtedness. - G: political and economic priorities. - X − M: income of trading partners, exchange rates, trade policies.
- Shifts of the AD curve caused by changes in the determinants. (AO2, AO4)
Guiding questions
- What makes the level of output and the price level move, and why do economists disagree about it?
Linking questions
- Components come from 3.1.
- The gaps defined here are what monetary policy in 3.5 and fiscal policy in 3.6 close.
- LRAS shifts are what supply-side policies in 3.7 aim at.
- Exchange rate changes in 4.5 are transmitted through X − M.
Practice questions
10 questions · 10 hardQuestion 1
HardPaper 1 · no calculator25 marks(a) Explain why, according to the Monetarist/New Classical model, an economy experiencing a deflationary (recessionary) gap will automatically return to its full employment level of output.
(b)
Using real-world examples, discuss the view that the Consumer Price Index (CPI) is an accurate measure of changes in the cost of living for a typical household.
Start by defining a deflationary gap and illustrating it on an AD/AS diagram. Then, focus on the key assumption of the Monetarist/New Classical school regarding the flexibility of wages and prices. How does this flexibility affect firms' costs and the SRAS curve?
Start by explaining what the CPI is and how it is constructed. Then, build a balanced argument. On one side, explain why it is a useful and widely accepted measure. On the other side, explore its limitations, such as substitution bias, quality changes, and the fact that the 'typical' household might not exist. Use examples of specific countries or situations to support your points.
Question 2
HardPaper 1 · no calculator25 marks(a) Explain the arguments for the imposition of trade protection.
(b) Using real-world examples, discuss the view that expansionary fiscal policy is more effective than expansionary monetary policy in lifting an economy out of a recession.
Think about the reasons why a government might want to restrict imports. Consider arguments related to new industries, jobs, national interests, and unfair practices by other countries. Try to explain at least three distinct arguments.
Start by explaining how both expansionary fiscal and monetary policies work to increase aggregate demand. Then, compare their strengths and weaknesses. Consider factors like time lags, political issues, and their effectiveness in different economic situations, such as a deep recession. Use a specific country's policy response to a recession (like the 2008 financial crisis or the COVID-19 pandemic) to support your arguments.
Question 3
HardPaper 1 · no calculator25 marks(a) Explain two factors that may cause a decrease in short-run aggregate supply.
(b) Using real-world examples, evaluate the effectiveness of monetary policy in controlling inflation.
Think about what determines the costs of production for firms across the whole economy. If these costs rise, what happens to the quantity of output firms are willing to supply at any given price level? Consider factors like wages, raw material prices, or government policies that affect business costs.
Start by explaining how contractionary monetary policy is supposed to work. Then, consider its limitations. Is it effective against all types of inflation? Are there time lags? What other factors might prevent it from working perfectly? Support your arguments with a real-world example of a country's central bank using monetary policy to fight inflation.
Question 4
HardPaper 1 · no calculator25 marks(a) Explain two factors that may cause an increase in short-run aggregate supply.
(b) Using real-world examples, evaluate the effectiveness of fiscal policy in reducing inflation.
Start by defining short-run aggregate supply (SRAS). Then, think about what determines the costs of production for firms across the whole economy. For each factor, explain the mechanism through which it leads to a rightward shift of the SRAS curve. Consider using a diagram to illustrate your explanation.
Define fiscal policy and explain how its contractionary form (higher taxes, lower government spending) is intended to work against demand-pull inflation. Use an AD/AS diagram. For your evaluation, consider the strengths (e.g., direct impact on AD) and weaknesses (e.g., time lags, political unpopularity, potential for causing unemployment). Support your points with specific examples of countries that have used fiscal policy to fight inflation.
Question 5
HardPaper 1 · no calculator25 marks(a) Explain how cost-push factors can lead to an increase in the general price level.
(b) Using real-world examples, discuss the view that monetary policy is the most effective way for a government to deal with inflation.
Start by defining cost-push inflation. Then, identify at least two specific factors that could increase firms' costs of production. Use a correctly labelled AD/AS diagram to show how an increase in production costs affects the short-run aggregate supply curve and, consequently, the equilibrium price level and real output.
To 'discuss', you need to present a balanced argument. First, explain how contractionary monetary policy works to reduce inflation. Then, consider its limitations and drawbacks. Compare its effectiveness to other policies like fiscal policy or supply-side policies, especially considering different types of inflation (demand-pull vs. cost-push). Support your arguments with specific real-world examples of countries that have used monetary policy to fight inflation.
Question 6
HardPaper 1 · no calculator25 marks(a) Explain two types of supply-side policies that a government could use to increase potential output.
(b) Using real-world examples, evaluate the view that market-based supply-side policies are more effective than interventionist supply-side policies in achieving a country's macroeconomic objectives.
Think about the two main categories of supply-side policies: market-based and interventionist. Choose one from each category and explain the mechanism through which it shifts the LRAS curve to the right. Don't forget to include a correctly labelled AD/AS diagram.
Structure your answer by first explaining the arguments for the effectiveness of market-based policies, then the arguments for interventionist policies. Consider different macroeconomic objectives like growth, unemployment, and inflation. To evaluate, you need to compare their strengths and weaknesses and use real-world examples to support your points. Conclude with a justified judgment.
Question 7
HardPaper 1 · no calculator25 marks(a) Explain how inward foreign direct investment (FDI) can contribute to economic growth.
(b) Using real-world examples, discuss the view that a lack of infrastructure is the most significant barrier to economic development.
Start by defining both foreign direct investment (FDI) and economic growth. Then, consider how FDI affects the components of aggregate demand and the determinants of long-run aggregate supply. Think about injections into the circular flow of income and factors that increase a country's productive capacity. A diagram would be helpful here.
To 'discuss' this view, you need to present a balanced argument. First, explain the ways in which poor infrastructure (e.g., transport, energy, sanitation) can hinder economic development. Then, challenge the view by considering other significant barriers (e.g., corruption, low levels of human capital, political instability) and argue why they might be equally or more important in some contexts. Use specific country examples to support both sides of your argument.
Question 8
HardPaper 1 · no calculator25 marks(a) Explain how a decrease in government spending on infrastructure and a depreciation of the country’s currency might affect macroeconomic equilibrium in the short run.
(b) Using real-world examples, evaluate the view that supply-side policies are the most effective way for a government to achieve economic growth.
Start by defining the key terms: government spending, currency depreciation, and macroeconomic equilibrium. Then, consider how each of these events affects a component of aggregate demand (AD). Use the AD/AS model to show the shifts and the resulting changes in the price level and real GDP for each event separately.
First, explain what supply-side policies are (both interventionist and market-based) and how they are intended to cause economic growth, using an LRAS diagram. Then, evaluate this view by considering the strengths of these policies (e.g., non-inflationary growth) and their weaknesses (e.g., time lags, costs, potential impact on equity). Compare their effectiveness to demand-side policies, considering different economic scenarios. Support your arguments with specific real-world examples of countries that have used supply-side policies.
Question 9
HardPaper 2 · calculator40 marksRead the extracts and answer the questions that follow.
Text A, Overview of the economy and government policies in Vietnam
1 Vietnam has one of the fastest-growing economies in Asia, driven by strong exports and high levels of foreign direct investment (FDI). This growth has transformed the country, lifting millions out of poverty. Major multinational corporations have established large-scale manufacturing facilities, particularly in electronics and textiles, turning Vietnam into a key hub in global supply chains.
2 This rapid industrialization, however, has created challenges. Inflation has become a persistent concern, fueled by rising domestic demand and higher global energy prices. The economy's heavy reliance on imported raw materials and components makes it vulnerable to supply chain disruptions and currency fluctuations.
3 To support its transition to a higher-value economy, the government has offered various incentives. For instance, it provides a subsidy to domestic producers of electric vehicles (EVs) to encourage green technology and reduce reliance on imported fossil fuels. The government has also been actively managing its currency, the Vietnamese dong (VND), to maintain export competitiveness.
Text B, Labour market and social development in Vietnam
1 Vietnam's economic boom has led to a significant structural shift, with millions of workers moving from agriculture to the industrial and service sectors. To ensure a basic standard of living, the government regularly increases the minimum wage. In 2022, the minimum wage was raised by an average of 6%.
2 While poverty has fallen dramatically, inequality is a growing concern. There is a widening gap in income and opportunities between major urban centres like Ho Chi Minh City and Hanoi, and the more remote, rural provinces. Although youth literacy rates are high, there is a recognized skills gap, where the education system is not fully equipping graduates for the demands of the modern high-tech manufacturing sector.
Text C, Vietnam's trade integration and environmental challenges
1 Vietnam is a member of numerous free trade agreements, including the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP) and the Regional Comprehensive Economic Partnership (RCEP). These agreements have boosted exports but also increased competition for domestic firms.
2 The environmental cost of industrialization is becoming increasingly apparent. Air and water pollution in industrial zones are significant problems, creating negative externalities that affect public health and long-term sustainability. The government acknowledges these issues and has set ambitious targets for renewable energy, aiming to attract FDI into solar and wind power projects.
Table 1: Selected macroeconomic data for Vietnam
| 2016 | 2022 | |
|---|---|---|
| Real GDP (USD billion) | 205 | 409 |
| Inflation rate (%) | 2.7 | 3.2 |
| Unemployment rate (%) | 2.3 | 2.3 |
| GNI per capita (USD) | 2190 | 4010 |
Table 2: Vietnam's current account, 2023 (billions of USD)
| 2023 | |
|---|---|
| Exports of goods | 355 |
| Imports of goods | 330 |
| Balance of trade in services | –10 |
| Primary income | –20 |
| Secondary income | 15 |
| Current account balance |
Table 3: Development and trade data for Vietnam
| 2016 | 2022 | |
|---|---|---|
| Population (million) | 93 | 99 |
| Gini coefficient | 0.344 | 0.357 |
| FDI inflows (USD billion) | 12.6 | 15.7 |
(a) (i) Define the term subsidy indicated in bold in the text (Text A, paragraph 3).
(a) (ii) Define the term Gini coefficient indicated in bold in Table 3.
(b) (i) Using information from Table 2, calculate Vietnam's balance of trade in goods for 2023 in billions of USD.
(b) (ii) Using information from Table 2 and your answer to part (b)(i), calculate Vietnam's current account balance for 2023 in billions of USD.
(b) (iii) Sketch a demand and supply diagram to show the effect of a subsidy on the market for electric vehicles in Vietnam (Text A, paragraph 3).
(c) Using an AD/AS diagram, explain how an increase in foreign direct investment (FDI) could affect economic growth in Vietnam (Text A, paragraph 1).
(d) Using a Lorenz curve diagram, explain the change in income inequality in Vietnam between 2016 and 2022 as shown in Table 3.
(e) Using an externalities diagram, explain how industrial production can lead to market failure in Vietnam (Text C, paragraph 2).
(f) Using an exchange rate diagram, explain how a rise in export revenue could affect the value of the Vietnamese dong (VND).
(g) Using information from the text/data and your knowledge of economics, discuss the challenges Vietnam faces in achieving sustainable economic development.
Think about what a government gives to a firm to help it produce more or sell at a lower price. What is the nature of this financial support?
This is a numerical measure of income inequality. How is it derived and what do its extreme values (0 and 1) represent?
The balance of trade in goods is the value of goods exported minus the value of goods imported.
The current account balance is the sum of the balance of trade in goods, the balance of trade in services, primary income, and secondary income.
A subsidy lowers the cost of production for firms. How does this affect the supply curve? Show the new equilibrium price and quantity.
FDI is a form of investment. Which component of aggregate demand (AD) does investment fall under? How would an increase in this component affect the AD curve and, consequently, real GDP?
First, look at the Gini coefficient data in Table 3. Did it increase or decrease? What does this mean for income inequality? Then, draw a Lorenz curve diagram showing two curves, one for 2016 and one for 2022, that reflects this change.
Industrial production often creates pollution. Is pollution a cost to the producer or to society? This creates a divergence between private costs and social costs. Illustrate this on a diagram and explain why it leads to overproduction.
When Vietnam's export revenue rises, what must foreigners do to pay for these exports? Does this affect the demand for or supply of the Vietnamese dong? Show the effect on an exchange rate diagram.
Sustainable development has economic, social, and environmental dimensions. Use the stimulus material to identify challenges in each of these areas (e.g., inflation, inequality, pollution). Then, consider any mitigating factors or policies mentioned. Conclude with a balanced judgement on the severity of these challenges.
Question 10
HardPaper 1 · no calculator25 marks(a) Explain two factors that could cause an appreciation of a country’s currency in a floating exchange rate system.
(b) Using real-world examples, evaluate the likely effects of a currency appreciation on a country’s rate of inflation and its economic growth.
Start by defining 'appreciation' and 'floating exchange rate'. Then, think about the demand for and supply of a currency. What would cause the demand to increase or the supply to decrease? For each factor, use a diagram to illustrate the effect on the exchange rate.
Consider both the demand-side and supply-side effects of a stronger currency. For inflation, think about the prices of imports (both consumer goods and raw materials). For economic growth, think about the net exports component of aggregate demand. Your evaluation should consider factors that determine the size of these effects, such as the price elasticity of demand for exports and imports, and discuss potential conflicts or trade-offs. Use a specific country example to support your arguments.
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Where marks are lost
- No real-world example, or a stated one. An answer that names a country and stops cannot reach the top two bands.
- One-sided argument. Balance is an explicit axis. A student who argues only that a policy works is capped at 9 out of 15 on that axis alone.
- Diagram present but not explained. The diagram bullet escalates across three bands: included, included and explained, included and fully explained. A diagram dropped into an answer without prose that refers to it sits at 5 to 6 on a 10-mark part.
