AD-AS Model

Question 1

Explain the mechanism that depicts the AD curve from the IS-LM model?

Answer 1

When M is fixed, an increase in P -> fall in supply (M/P) -> upward shift of LM curve and tf a fall in Y

Tf increase P -> fall in Y (AD relationship)

SEE DIAGRAM

Question 2

Shifts in AD curve?

Answer 2

Anything that changes total amount of spending in economy shifts AD curve (increase -> outward shift, vice versa)

Question 3

In the long run, what shape is the LRAS curve? Why?

Answer 3

Vertical because an economy’s labour, capital and production technology determine AS tf output level does not depend on price level

Question 4

What is the natural level of output?

Answer 4

The point where unemployment is at its long run natural rate (roughly 4%)

Question 5

How does an increase in central bank money supply affect the AD-AS model?

Answer 5

It shifts AD right

Question 6

How will technological progress affect the AD-AS model?

Answer 6

It will shift the LRAS right

Question 7

What shifts the LRAS curve?

Answer 7

Anything that alters the natural rate of output

Question 8

What shape is the SRAS curve and why?

Answer 8

Horizontal - in the short run prices are ‘sticky’ since price catalogues etc. have already been issued tf increase AD/Y will not cause increase in P

Question 9

Explain the effects of an increase in labour force in SR and LR?

Answer 9

SR: increase LF -> decrease wage rate tf shift down of SRAS

LR: increase LF -> increase factors of production -> shift right of LRAS

Both of these happen since the shift in LRAS causes a decrease in input prices (higher income for same prices)

Question 10

What factors shift the SRAS curve only?

Answer 10

Changes in the economy that alter the cost of producing G+S shift the SRAS curve only

Question 11

Where is the LR equilibrium in AD-AS?

Answer 11

When AD=LRAS(=SRAS)

Question 12

Draw AD-AS diagram showing the stages of a contraction in AD? Explain the SR and SR to LR mechanisms?

Answer 12

Negative demand shock: A->B

From SR to LR: higher U -> lower wage rate -> Fall in SRAS curve tf since prices are lower -> increase D -> decrease U ending up at point C

Question 13

What is the difference between the Keynesian and classical approach to AS?

Answer 13

Classical: prices are flexible tf output is always at natural level

Keynesian: prices are sticky tf changes to AD can cause output to deviate from natural rate

Question 14

Define recessionary gap?

Answer 14

The output gap that occurs when actual rate < natural rate

Question 15

What are the IS and LM equations? How is the equilibrium found in both Keynesian and classical approach?

Answer 15

IS: Y = C(Y-T) + I(r) +G(fixed)
(T fixed too)

LM: M/P = L(r,Y) (M is fixed too)

Tf 3 unknowns: Y, P and r

3rd equation is needed to solve it:
Keynesian assumes P is fixed tf P=P(hat)
Classical assumes Y is fixed tf Y=Y(hat)

Question 16

What causes a movement along the AD curve?

Answer 16

When a change in P -> a change in income in the IS-LM model

Question 17

Explain how an increase in the money supply affects AD?

Answer 17

Increase M -> shift down of LM curve (see previous for reasons):
Tf there’s a higher Y for a given price level P, so the AD shifts right

Vice versa

Question 18

Explain how fiscal policy affects AD?

Answer 18

Increase G -> increase AE^P -> increase Y (for a given r) tf IS curve shifts right tf for every given P there’s an increase in Y tf AD shifts right too

Question 19

Explain the upward sloping SRAS curve?

Answer 19

Allows price level to change in the SR - prices are flexible tf firms supply more at higher prices

Question 20

Why can firms make larger profits when prices are higher? Why does this happen?

Answer 20

Output prices rise relative to input prices tf profit margins increase

Why?
Contracts on wages and rent are often fixed in SR tf don’t increase in SR (STICKY WAGE THEORY)

Question 21

2 reasons unemployment falls in SR when there is a positive demand shock(increase AD)?

Answer 21

• living costs increase tf effort for unemployed people to work increases (eg. More likely to accept a lower wage job than before, more likely to travel further willingly for a job)
• firms are getting higher profits tf expanding output tf hiring more workers

Question 22

Effect of a positive demand shocks in the long run (on unemployment)?

Answer 22

Higher price level -> fall in real wage (W/P) -> dissatisfaction -> increase in wage -> upward shift of SRAS -> increase unemployment

Back to LR equilibrium but at higher P

See diagram page 13 L10

Question 23

2 causes of inflation?

Answer 23

Demand pull inflation = price level increases as a result of AD

Cost-push inflation = inflation caused by supply side forces (eg. Increases in cost of production)

Question 24

Define inflationary gap?

Answer 24

The output gap that occurs when the actual output is greater than the natural rate

Question 25

Important thing about the shifts of AD and SRAS in the long run?

Answer 25

SRAS in long run will tend back to original point following a shift

AD will not tf there will be a new LR equilibrium (diff price level same output level)

Question 26

What is the Keynesian view on policy management?

Answer 26

Keynesian view says that economic downturns happen due to demand deficiency tf to stimulate economy either decrease tax or increase G

Question 27

What can cause a shift in both the SRAS and the LRAS?

Answer 27

Any change in the quantity of any factor of production available and/or technology