9: Aggregate Demand and Supply

Question 1

3 Effects

Answer 1

1. Wealth Effect
2. Interest-Rate Effect
3. Exchange-Rate Effect

Question 2

Wealth Effect - Suppose P rises…

Answer 2

• The dollars people hold buy fewer goods and services, so real wealth is lower
• People feel poorer
• People spend less so C falls
• And if C falls then AD falls and Y falls

Question 3

Interest-Rate Effect - Suppose P rises…

Answer 3

• Buying goods and services requires more dollars because everything is now more expensive
• To get these dollars, people try to borrow more money
• Increase in demand for borrowing, drives up interest rates
• When interest rates rise, firms undertake less investment spending
• Thus I falls, AD falls and Y falls

Question 4

Exchange-Rate Effect - Suppose P Rises…

Answer 4

• More foreign investors want to invest in Australian bonds, and more money flows into Australia;
• Higher demand for $AUD increases its value (Australian dollar appreciates).
• This makes Australian exports more expensive to foreigners (so X) but imports into Australia cheaper (so M)
• If NX falls, AD falls and Y falls

Question 5

Changes in C - AD Curve Shift

Answer 5

• Stock market boom/crash
• Changes of preferences (suddenly prefer more consumption over saving - boom/ less consumption over saving - recession)
• Taxes are reduced (so have more money to spend) or increased (so have less money to spend).

Question 6

Changes in I - AD Curve Shift

Answer 6

• Firms buy new computers, equipment, factories
• Expectations: firms become more optimistic/more pessimistic
• Interest rates are reduced or increased by monetary policy
• Investment incentive schemes are introduced or removed.

Question 7

Changes in G - AD Curve Shift

Answer 7

• Federal spending is increased or reduced, e.g., defense

- State & local spending is increased or reduced, e.g., more roads, fewer schools

Question 8

Changes in NX - AD Curve Shift

Answer 8

• Booms/recessions in countries that buy our exports

- Appreciation/depreciation of $AUD resulting from international speculation in foreign exchange market

Question 9

Why the LRAS Curve might shift (4)

Answer 9

1. Changes in Un or natural rate of employment
2. Changes in physical, capital or human capital
3. Changes in natural resources
4. Changes in technology

Question 10

3 SRAS Theories

Answer 10

1. Sticky Wage Theory
2. Sticky Price Theory
3. Misperception Theory

Question 11

Sticky Wage Theory

Answer 11

• Imperfection: Nominal wages are sticky in the short run.

* They adjust sluggishly due to labour contracts, social norms, etc

Question 12

Sticky Price Theory

Answer 12

Many prices are sticky in the short run  cost of printing new menus (menu cost), time required to change prices

Question 13

Misperception Theory

Answer 13

Firms may confuse changes in the average price level P with changes in the relative price of the products they sell.

Question 14

Short-run equilibrium

Answer 14

when AD and SRAS lines intersect

Question 15

Long-run equilibrium

Answer 15

AD hits LRAS and unemployment is at its natural rate. The economy is at full employment equilibrium.