10. Aggregate Demand and Aggregate Supply

Question 1

recession

Answer 1

period of declining real incomes and rising unemployment (mainly due to insufficient demand)

Question 2

classical theory predicts

Answer 2

long term, not short term

Question 3

what does the aggregate-demand curve show

Answer 3

shows the quantity of total goods and services that households firms and governments want to buy at each price level

Question 4

what does the aggregate-supply curve show

Answer 4

shows the quantity of goods and services that choose to produce and sell at each price level

Question 5

why does aggregate demand curve slope downwards

Answer 5

wealth effect, when prices goes down, people feel wealthier meaning increase in spending/demand (impacts on C)

Keynesian effect, when price falls, people don’t need to use as much money and so they might try to buy bonds or save -> more loanable funds and investment increases (impacts I)

Mundell-Fleming: NX: lower price -> less inflation -> rate of interest decreases

investors will invest overseas (higher interest overseas). This increases supply to the foreign exchange market, depreciating the NZ dollar. This means more exports and less imports, thus increasing NX.

Question 6

what two variables are used to develop the model of aggregate demand/supply

Answer 6

real GDP, and the overall price level (GDP deflator or CPI)

Question 7

what affects aggregate-demand curve

Answer 7

C I G NX

Question 8

in the long-term, aggregate supply curve is

Answer 8

vertical

Question 9

the quantity at the aggregate supply curve is also known as

Answer 9

the potential output or full-employment output OR natural output

Question 10

factors that can shift the long-term aggregate-supply curve and WHAT HAS NO AFFECT CAPS!!!!

Answer 10

labour, capital, natural resources, technological knowledge, government policies PRICE LEVEL OR MONEY SUPPLIED HAS NO EFFECT

Question 11

what makes the short-term aggregate supply curve slope upwards?

Answer 11

price

sticky-wage theory
WAGES are fixed, so when prices fall the overall costs for the business increases so the company will hire less and reduce output

sticky-price theory
changing prices are costly so they don’t change too fast, if the price drops then sales are reduced, and they will cut back on employment and production

misconception theory
change in price level causes temporary misperception in suppliers to reduce supply - if price of tomatoes are reduced then suppliers think that it’s not worth supplying as much. vice versa for higher - as long as it deviates from EXPECTED prices

Question 12

in the long run, what happens to sticky wages and sticky prices, misconceptions, and the aggregate supply curve?

Answer 12

sticky become unstuck, misconceptions are cleared and the curve becomes the vertical long term supply curve

Question 13

what can shift the short-term aggregate supply curve?

Answer 13

labour, capital, natural resources, technological knowledge

Question 14

what happens to aggregate demand if people become pessimistic?

Answer 14

spend less -> consumption decreases, meaning businesses invest less, AD = CIG NX leads to recession (USE DIAGRAM) GDP decreases, more unemployment. Price level will decrease

Question 15

two problems when trying to increase aggregate demand through government injections

Answer 15

TIME LAG
government discussion, parliament, takes about 18 months to get fiscal policy through

SPEED
economy will fix itself slowly over time, if policy is implemented late it will overshoot into INFLATION

PRECISION
hard to get back to equilibrium, do not offshoot into inflation (hard to do as humans are unpredictable)

Question 16

how to fix recession?

Answer 16

government injection - create jobs etc. increase consumption -> increase investment

or

do nothing policy, allow economy to cure itself

Question 17

downward pressure on wages

Answer 17

recession has many unemployed, people willing to work for lower wages -> cost of production decreases, impacting on the short term aggregate supply, restoring equilibrium

Question 18

effect of oil shock

Answer 18

shifts short term aggregate supply curve to the left as cost of production increases, WORSE than aggregate demand shift STAGFLATION

Question 19

how do we fix stagflation? from the reserve bank, government and doing nothing.

Answer 19

cannot fix rising prices and decreasing output at the same time;

expansionary monetary policy -reserve bank governor. Decreasing OCR, decreasing interest rates. Borrowing more -> investment increases, and people borrow more. Aggregate demand increases -> more inflation

contractionary monetary policy -> increase OCR, interest rate increases, less borrowing. Inflation decreases but unemployment worsens.

expansionary fiscal policy (increase aggregate demand & return to natural output, the new price is high so we get INFLATION)-

contractionary fiscal policy - reduce spending, demand decreases. Inflation decreases but now we have less output and more unemployment)

do nothing (best as there will be a downward pressure on wages, pushing short-term aggregate supply back) MUST ANALYSE ALL