Explain how a decrease in business confidence can affect the real GDP of an economy that is producing below the full employment level of output.

Evaluate the view that a decrease in aggregate demand would always be deflationary.

Marks should be allocated according to the paper 1 markbands for May 2013 forward, part A.

Answers may include:

• definitions of real GDP, business confidence, full employment level of output
• diagram to show how a decrease in business confidence will shift AD to the left, resulting in a decrease in real GDP
• explanation that business confidence is a determinant of investment and a decrease in confidence will lead to a decrease in AD and a decrease in real GDP
• examples of situations where business confidence has fallen.

Marks should be allocated according to the paper 1 markbands for May 2013 forward, part B.

Answers may include:

• definitions of aggregate demand, deflationary
• diagram to show a fall in AD leading to a fall in the average price level in the neo classical/monetarist model
• explanation that in the neo classical/monetarist model a fall in AD would be deflationary because a fall in AD leads to a new equilibrium income at a lower average price level and real GDP
• examples of economies that have experienced a decrease in AD, which is deflationary
• synthesis or evaluation.

Evaluation may include: When AD falls in the Keynesian model and the economy is below full employment the average price level does not fall because wages and costs tend not to fall.

NB Candidates can approach this question in terms of deflationary conditions in the economy or as deflation.

This question was well answered by many candidates. The key terms of business confidence, real GDP and full employment were mostly well defined and the impact of a fall in business confidence on real GDP was clearly explained with an effective AD/AS diagram. Weaker answers tended to be imprecise in the explanation of business confidence and needed to be clearer on the meaning of full employment.  

This question proved to be quite challenging for students because the term "deflationary" can be answered as falling prices or falling output when there is a deflationary gap. Most candidates chose to focus on falling prices and there were some very good answers to this with students focusing on the Keynesian AS where falling aggregate demand will cause deflation if output is at or near full employment. When, however, output is below full employment, falling aggregate demand will not cause deflation because wages are 'sticky' downwards. Some students were drawn onto the Neo-classical LRAS which has another approach that could be used effectively to explain how falling aggregate demand will always cause deflation. Some students used real world examples here, but many found it difficult to build one into their answer.