AD-AS Flashcards
Why can Business Cycles be bad for an Economy?
Recessions–> Unemployment
Booms–> Inflation + Bubbles (potentially)
What is a Recession?
- Economic Contraction
- Period of Decreased Real Incomes + Increased Unemployment
2 Consecutive Quarters of Negative Real GDP Growth
What is a Depression?
Severe Recession
What are the 3 main Facts about Economic Fluctuations?
- Economic Fluctuations are Irregular + Unpredictable
- Most Macroeconomic quantities fluctuate together
- As Output falls–> Unemployment Rises
What are the 2 main building blocks of Classical Economic Theory for SR Fluctuations?
Classical Dichotomy
Monetary Neutrality
What is Classical Dichotomy?
Separating Nominal + Real Variables
What is Monetary Neutrality?
Changes in M.S affect Nominal but NOT Real variables
- Can examine determinants of Real Variables without reference to Nominal variables
According to Classical Economic Theory, what happens in SR?
Assumption of Monetary Neutrality- No longer appropriate
- Real + Nominal variables are intertwined
- Changes in M.S- can temporarily push Real GDP away from its LR trend
THEREFORE- Need a NEW SR Model
What is Controversial about Real Business Cycle Theory?
Business Cycles occur Naturally- NOT due to Sticky Prices
- Trying to remove Cycles- Distort Market Mechanism- worsen situation
What does the AD-AS model show?
Explains SR fluctuations in Economic activity around LR trend
- Focusses on relationship between Prices + Real GDP
What does AD show?
Quantity of G+S Households, Firms, Gov. + Customers Abroad want to Buy at each Price Level
What is the Price Level?
Aggregate Price Index- e.g. GDP Deflator, CPI etc.
What 3 things explain why AD is Downward Sloping?
- Wealth Effect - C
- Interest-rate Effect - I
- Exchange Rate Effect - NX
Assume G is a Fixed Policy
What is the Wealth Effect?
Decreased Price Level –> Increased Value of Money –> Consumer feels Wealthier + Increases C –> Increased AD
What is the Interest-rate Effect?
Decreased Price Level –> Need to hold less Money–> Reduced M.D –> Increases Private Savings–> Increased S of Loanable Funds–> Decreased I.R –> Increased I–> Increased AD
What is the Exchange Rate Effect?
Fall in UK Price Level –> Decreased I.R–> Increased NCO + S of £ on FX Market–> Fall in £ ER–> Increased X + Decreased M–> Increased NX–> Increased AD
If Price Levels Increase, what happens to C, I + NX?
- Consumers Poorer- Decreased C
- Increased I.R- Decreased I
- Increased £ ER- Decreased NX
Decreased Qd for G+S
What is the relationship between P and QD for G+S?
NEGATIVE- AD Downward Sloping
What can cause AD to Shift?
Changes in C, I, G + NX
What changes in C can Shift AD?
Events that change how much people want to consume at a Given Price Level
- e.g. Change in Taxes, Wealth…
What changes in I can Shift AD?
Events that change how much firms want to invest at a Given Price Level
- e.g. Better Technology, Changes in Taxes or M.S
What changes in G can Shift AD?
Policy makers can change G at a Given Price Level
- e.g. Build new roads
What changes in NX can Shift AD?
Events that change NX for a Given Price Level
- e.g. Recession in Trading Partners
What does AS show?
Quantity of G+S firms Produce + Sell at a Given Price Level
What is LRAS?
Price Level does NOT affect LR determinants of GDP
- Supplies of Labour, Capital, Natural Resources + Technology matter for LRAS
- Classical Dichotomy + Monetary Neutrality hold
Where is LRAS Vertical?
At Natural Rate of Output
- Production of G+S in LR when Unemployment at NRU
What causes a Shift in LRAS?
- Changes in Labour- immigration, births, policy to change Frictional + Structural Unemployment
- Changes in Capital- affects Productivity
- Changes in Natural Resources
- Changes in Technology + Technological Knowledge
What can shift in LR?
Both AD + LRAS
What does Technological Progress lead to?
Continual Shift of LRAS to Right
In LR- what type of Policy shifts AD to Right?
Monetary Policy
What is the Result of AD + LRAS shifting to the Right?
Continuing Growth in Output
- Continuing Inflation
In SR- how are Price Level + Qs of G+S related?
- Increased Price Level–> Increased Prices + Profitability–> Increased Qs of G+S
- Decreased Price Level–> Decreased Prices + Profitability–> Decreased Qs of G+S
What 3 things explain why SRAS is Upward Sloping?
- Sticky-Wage Theory
- Sticky-Price Theory
- Misperceptions Theory
Cause Output to deviate from Natural Level due to Actual P ≠ Expected P
What happens if P rises above Expected Level?
Output Increases ABOVE Natural Rate
What is Sticky-Wage Theory?
- Nominal Wages- Slow to adjust to changing Econ. conditions- due to fact Labour contracts are fixed in Medium Term
- Nominal Wages- based on Expected Prices- Do NOT respond immediately when Actual deviates from Expected
Under Sticky-Wage Theory, what happens if Price Level < Expected Level?
Firms- Incentive to Reduce Output- Wages/Prices Higher than expected
–> Increased CoPs–> Hire less workers
Under Sticky-Wage Theory, what happens if Price Level > Expected Level?
Firms- Incentive to Increase Output- Wages/Prices Lower than expected
–> Decreased CoPs–> Hire more workers
What is Sticky-Price Theory?
Prices of some G+S: - Slow to Adjust + Menu Costs
Under Sticky-Price Theory, what happens if Price Level < Expected Level?
Some Firms have Higher Prices than desired –> Decreased Sales + Decreased Output
What is Misperceptions Theory?
Changes in Overall Price Level- can temporarily mislead supplier about changes in Individual Markets
- Mistakenly Infer changes in absolute Prices as a change in Relative Prices
- Suppliers respond to changes in level of Prices–> Changes in Qs of G+S
Under Misperceptions Theory, what happens if Price Level < Expected Level?
Some suppliers might think this represents Reduced Relative Demand for their Product–> Reduced Output
How is Qs calculated?
Qs = NRO + a( Actual PL - Expected PL )
where a determines how much output responds to Unexpected changes in PL
What happens to SRAS in LR + why?
In LR- Actual Prices = Expected Prices
–> SRAS = LRAS
What causes a Shift in SRAS?
Changes in: Labour, Capital, Natural Resources, Technological Knowledge
- Expected Price Increases–> SRAS LEFT Shift
