2.2 AD, AS, Policy Flashcards
AD
total spending on domestic g/s
at different PL in a time period
Why is AD downward sloping?
- 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
Components of AD
- 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
AS
total amount of g/s produced by an economy
at different PL in a time period
Distinguish SR vs. LR
SR: wage is fixed despite changes in PL
LR: wage changes with PL
Distinguish shifts in SRAS vs. LRAS
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
Distinguish between SRAS and LRAS
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
Explain the differences between Monetarist and Keynsian views
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)
Deflationary Gap
- real GDP < potential GDP, UE > natural rate
- due to insufficient AD
Inflationary Gap
- real GDP > potential GDP, UE < natural rate
- due to increase in AD
- only SR!!
Full Employment Level of Output
- equilibrium real GDP = potential GDP
- UE = natural rate
Macroeconomic Equilibrium
- AD = AS (Keynesian图)
Fiscal Policy
government’s use of spending and taxation
to influenece AD and achieve macroeconomic goals such as economic growth, full employment, low and stable inflation…
Monetary Policy
central bank’s use of IR and money supply
to influenece AD and achieve macroeconomic goals such as economic growth, full employment, stable inflation…
Supply-Side Policy
gov policies to increase the quantity/quality of FOP –> shift LRAS to the right and increase potential output
Gov’s Budget
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!!
Goals of Fiscal/Monetary Policy
- stable EG
- low UE
- low and stable INF
- reduce fluctuations in the business cycle
- equitable distribution of income
- balance of trade
Distinguish between real vs. nominal interest rates
real = nominal - inflation
Explain the process of money creation by central banks
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
Explain the mechanics of automatic stabilizers (can use to evaluate fiscal policy)
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↓
Business Cycle
The SR fluctuations of real GDP around its LR trend
Potential output
output produced by an economy when it is at full employment level
Recession
real GDP falls for two consecutive quarters
Explain the Keynesian Multiplier
- increase in G shift AD to the right
- 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)
Crowding Out
gov borrow from private sectors to finance G
–> private sector C+I fall
–> expansionary FP not effective in increasing AD
