AD-AS model

Question 1

What’s the difference between the short run and medium run in the AD-AS model?

Answer 1

In short run, we assume prices are sticky (or at least sluggish!) However, in the medium run, we assume prices are flexible, and output will return to it’s natural level (based on an economy’s productive capacity).

Question 2

How do we derive the AD curve, and what is it?

Answer 2

AD curve shows the effects of changes in price on output. It is derived from the equilibrium conditions in the goods and financial markets.
Derivation: Assume P increases&raquo_space; Money supply falls&raquo_space; i increases&raquo_space; Y falls.
This is why the AD curve is downward sloping!

Question 3

How do monetary policy variables affect the AD curve?

Answer 3

• Government spending has a positive relationship with Y (increase shifts AD to the right)
• Money supply also has a positive relationship (decrease in money supply causes shift to left / up of AD)
• Taxes have a negative relationship with Y (increase in taxes, causes leftward/upward shift in AD