11 Aggregate Demand, Aggregate Supply and Macroeconomic Policy

Question 1

Aggregate Demand and Supply curve x & y axis

Answer 1

X: Output Y (real GDP)
Y: Inflation rate (pie)

On graph:
AD
AS: Short-run
AS (vertical line): Long-run (Y*) - potential output

All 3 intersect means at LONG-RUN equilibrium

Question 2

Contractionary gap occurs when actual output (more/less) than potential output

Expansionary gap (more/less)

Answer 2

LESS

MORE

Question 3

Aggregate demand (AD) curve shows

Answer 3

Total amt of output at each inflation rate by consumers, firms, govt, foreigners

When inflation rate is high
- C, IP, NX decrease
- PAE decrease
- Y decrease

Question 4

2 main causes in shift in Aggregate Demand (AD) curve

Answer 4

1. Demand shocks
   (factors that cause C, I, G, NX to change other than inflation rate)
   - Consumer confidence
   - Consumer wealth
   - Business confidence
   - Opportunities to buy new technologies
   - Foreign demand for domestic good
2. Stabilization policy
   - Fiscal policy - change in govt spending/ taxes (C&G)
   - Monetary policy - change in money supply by central bank which changes interest rate (I)

Question 5

Aggregate Supply (AS) curve shows

Answer 5

r/s between amt of output FIRMS want to produce and inflation rate

Inc in AD will Inc willingness to supply and Inc inflation rates

Question 6

Inflation inertia

Answer 6

Inflation will remain relatively constant so long economy is at potential output and no external shocks

If past few years inflation rate is low - expected inflation for following years is low - output has low

Question 7

What happens to behaviour of inflation when r/s of output & potential output changes

Answer 7

Expansionary gap Y>Y* : Inflation INC (so ppl buy less)

Y=Y*: Inflation STABLE

Recessionary gap Y<Y*: Inflation DEC (encourage ppl to buy more)

Question 8

Current inflation formula

Answer 8

Current inflation (pie) = expected inflation (pie e) + inflation from an output gao

Question 9

3 main causes in shift in Aggregate Demand (AD) curve

Answer 9

• Changes in avail resources and technology (inc, shift right)
• Changes in inflation expectations (inc, shift LEFT - high inflation will ask for higher wage, hire less workers, produce less output)
• Inflation shock (not related to output gap eg resource price inc)

Question 10

How do curves shift when:
Favourable demand shock
Unfavorable demand shock

Favourable supply shock

Answer 10

Favourable demand shock: D shift right
Adverse demand shock: D shift left

Favourable supply shock: S shift right
Adverse demand shock: S shift left

Question 11

When there is expansionary gap, 2 things can happen

Answer 11

1. Govt change policy to close output gap
2. Govt do nth, let self-correction mechanism close output gap by itself (no change in AD curve)

Question 12

Expansionary gap:
When expected inflation inc, workers demand for (higher/lower) wages, firms employ (more/less) workers, produce (more/less) output, AS (increase/decrease) and shifts (right/left)

Answer 12

When expected inflation inc, workers demand for HIGHER wages, firms employ LESS workers, produce LESS output, AS DECREASE and shifts LEFT

until curve shifts to Y* (potential output)
- C, I, NX will drop

Question 13

What to do when expected inflation change (to close output gap)? Shift AD or AS curve?

Answer 13

Shift AS curve - when expected inflation change - when wages change

Question 14

Self-correcting mechansim:

Answer 14

If slow - use fiscal and monetary policy to stabilize economy

If fast - just let it self-correct. using ^ may not be effective and destabilize economy

Question 15

Using stabilization policy to close output gap - shift AD or AS curve?

Answer 15

AD curve to the right to Y*

• Increase in govt spendings (G inc)
• Decrease taxes (C inc)
• Increase money supply to lower interest rate (I inc)

Question 16

Anchored inflationary expectations

Answer 16

Ppl’s expectations of future inflation do not change even if inflation rises temporarily

• Shortens time required to close recessionary gap from shock

Question 17

Central bank (MS is vertical line)

Tax reductions causes AD & AS to

Answer 17

Both shift right