2.2 AD, AS, Policy

Question 1

AD

Answer 1

total spending on domestic g/s
at different PL in a time period

Question 2

Why is AD downward sloping?

Answer 2

• Wealth effect: PL rise → real value of wealth fall → people feel they have less disposable income → C fall → AD fall
• Interest Rate effect: PL rise → consumers and firms need to borrow more $ to maintain living standard → D for $ rise → IR rise → cost of borrowing increase → C & I fall → AD fall
• International Trade effect: PL rise → exports dearer, imports cheaper → X fall, M rise → AD fall

Question 3

Components of AD

Answer 3

• C = total spending by households on domestic g/s
• I= total spending by firms on capital goods
• G= total spending by gov
• X-M= total revenue from export - spending on import

Question 4

AS

Answer 4

total amount of g/s produced by an economy
at different PL in a time period

Question 5

Distinguish SR vs. LR

Answer 5

SR: wage is fixed despite changes in PL
LR: wage changes with PL

Question 6

Distinguish shifts in SRAS vs. LRAS

Answer 6

Shifts in SRAS are caused by changes in COP
eg. cost of FOP, indirect tax, supply shocks

PL increase
→ firms can increase P whilst wages remain fixed
→ higher revenue + lower cost = higher profitability
→ incentivize firms to increase output.

Shifts in LRAS are only caused by changes in quantity/quality of FOP
LRAS is independent of PL because increase in PL is offset by increase in price of FOP
→ no profit incentive
→ firms always produce at potential GDP

Question 7

Distinguish between SRAS and LRAS

Answer 7

SRAS: real GDP at different PL when wage is fixed despite changes in PL; shifted by changes in COP

LRAS: real GDP at different PL when wage changes with PL; only shifted by changes in quantity/quality of FOP

Question 8

Explain the differences between Monetarist and Keynsian views

Answer 8

Monetarist:
1. Increases in AD always inflationary → economic policy should shift LRAS
2. Increases in AD can always increase Y in SR, but always returns to Yp in LR
2. The economy will always self-correct to Yp in the LR as factor prices are flexible to adjust up/downwards.

Keynsian:
1. When the economy is operating under Yp (horizontal section of AS), increases in AD can increase Y without inflationary pressure → economic policy should stimulate AD during recession
2. When the economy is operating at full capacity (vertical section of AS), increases in AD cannot increase Y anymore, outcome is only inflationary
3. The economy can be stuck in deflationary gap as wages are inflexible downwards (contracts, trade union, min wage) → need for gov to steer the economy to Yp using demand-side policies (fiscal and monetary)

Question 9

Deflationary Gap

Answer 9

• real GDP < potential GDP, UE > natural rate
• due to insufficient AD

Question 10

Inflationary Gap

Answer 10

• real GDP > potential GDP, UE < natural rate
• due to increase in AD
• only SR!!

Question 11

Full Employment Level of Output

Answer 11

• equilibrium real GDP = potential GDP
• UE = natural rate

Question 12

Macroeconomic Equilibrium

Answer 12

• AD = AS (Keynesian图)

Question 13

Fiscal Policy

Answer 13

government’s use of spending and taxation
to influenece AD and achieve macroeconomic goals such as economic growth, full employment, low and stable inflation…

Question 14

Monetary Policy

Answer 14

central bank’s use of IR and money supply
to influenece AD and achieve macroeconomic goals such as economic growth, full employment, stable inflation…

Question 15

Supply-Side Policy

Answer 15

gov policies to increase the quantity/quality of FOP –> shift LRAS to the right and increase potential output

Question 16

Gov’s Budget

Answer 16

A gov budget is a plan for revenue and spending for the coming year (budget = revenue - spending)

revenue:
* direct tax - taxes on income/profit/wealth paid directly to the government
* indirect tax - tax on expenditure to buy g/s
* sales of state-owned asset/enterprise

spending:
* current - recurring payments
* capital - investments on physical capital (eg. infrastructure)
* tansfer - payments to redistribute income (eg. benefit) THIS DOESN’T CONSIST AD!!

Question 17

Goals of Fiscal/Monetary Policy

Answer 17

• stable EG
• low UE
• low and stable INF
• reduce fluctuations in the business cycle
• equitable distribution of income
• balance of trade

Question 18

Distinguish between real vs. nominal interest rates

Answer 18

real = nominal - inflation

Question 19

Explain the process of money creation by central banks

Answer 19

when commercial bank receive $ from a saver → bank keep a minimum reserve ratio (RRR) and lend out the rest → a person takes loans from the commercial bank and use it to consume g/s → seller receive $ may also deposit in bank → commercial bank keep a RRR and lend out the rest → ……

This process of lending and making loans creates new $ in an economy.

The maximum $ that can be created is calculated through a money multiplier: 1/reserve ratio.

central bank can lower RRR or buy bonds from OMO and give commerical banks $ in exchange
= more excess reserves
= more loan
= more $ created

Question 20

Explain the mechanics of automatic stabilizers (can use to evaluate fiscal policy)

Answer 20

Automatic Stabilizers: part of fiscal policy, includes progressive taxation and UE benefits, automatically balances fluctuations in economic activity.

Real GDP↑ –> AD↑ –> inflationary gap
* income↑ = income tax↑ = Yd↓ = C↓, AD↓
* cyclical UE↓ = UE benefit ↓ = G↓ = AD↓

Question 21

Business Cycle

Answer 21

The SR fluctuations of real GDP around its LR trend

Question 22

Potential output

Answer 22

output produced by an economy when it is at full employment level

Question 23

Recession

Answer 23

real GDP falls for two consecutive quarters

Question 24

Explain the Keynesian Multiplier

Answer 24

1. increase in G shift AD to the right
2. additional income generated by increase in G leads to further spending + income…… further shifts AD to the right

The size of the Keynesian Multiplier depends on the size of the withdrawals (income not spent on domestic output)

= 1/(1-MPC) = 1/(MPS+MPM+MPT)

Question 25

Crowding Out

Answer 25

gov borrow from private sectors to finance G
–> private sector C+I fall
–> expansionary FP not effective in increasing AD