Aggregate Demand and Aggregate Supply (AD/AS) Model Flashcards
What is the AD/AS model used for?
It is a key macroeconomic framework used to explain the interplay between aggregate demand and supply, particularly in analyzing fiscal and monetary policy impacts.
What is the key question analyzed by the AD/AS model?
Does expansionary policy increase output and jobs (reflationary) or cause inflation?
What are the two types of aggregate supply in the AD/AS model?
Short-run aggregate supply (SRAS) and long-run aggregate supply (LRAS).
What is aggregate demand (AD)?
Total planned spending on goods and services within an economy over a time period.
What is the equation for aggregate demand?
𝐴𝐷=𝐶+𝐼+G+(𝑋−𝑀), where:
* C: Consumption (households)
* I: Investment (firms)
* G: Government spending
* X−M: Net exports (exports minus imports)
What is the difference between AD and national expenditure?
AD is planned spending, while national expenditure is actual spending.
What is the shape of the AD curve?
Downward sloping, showing an inverse relationship between price level and planned real output.
What causes shifts in the AD curve?
Changes in factors other than price level, such as consumer confidence, fiscal policy, or monetary policy.
What are the reasons the AD curve slopes downward?
- Wealth Effect: Lower price levels increase real money balances, encouraging spending.
- Interest Rate Effect: Lower price levels reduce interest rates, stimulating investment and consumption.
- Net Export Effect: Lower domestic price levels make exports more competitive and imports less attractive, increasing net exports.
What is short-run aggregate supply (SRAS)?
Planned production/output at various price levels, assuming fixed input costs like wages.
What is the shape of the SRAS curve?
Upward sloping; becomes steeper as output approaches full capacity.
What causes the SRAS curve to shift leftward?
Rising production costs, such as higher wages, raw material costs, or taxes.
What causes the SRAS curve to shift rightward?
Falling production costs or increased productivity.
Why does the SRAS curve slope upward?
Rising output leads to diminishing marginal productivity, which increases marginal costs, requiring higher prices for more production.
How do changes in the money wage rate affect the SRAS curve?
- Increase: Raises production costs, shifting SRAS left.
- Decrease: Lowers production costs, shifting SRAS right
What is the shape of the non-linear SRAS curve?
- Horizontal at low output (spare capacity).
- Steeper as output rises due to capacity constraints.
- Vertical at full capacity
What does the LRAS curve represent?
The maximum sustainable level of real output (𝑌𝑛) an economy can produce when all factors of production are efficiently employed.
Where is the LRAS curve located?
At the economy’s production possibility frontier (PPF), reflecting ‘normal capacity’ output, which is slightly below ‘full capacity’ output?
What is long-run macroeconomic equilibrium?
It occurs where LRAS intersects aggregate demand (AD) and short-run aggregate supply (SRAS).
What is the difference between ‘normal capacity’ and ‘full capacity’?
- Normal Capacity: Sustainable production level without inflationary pressures or overuse of resources.
- Full Capacity: Maximum output achievable temporarily through overtime, higher factor inputs, or short-term measures.
What happens when an economy operates above normal capacity?
It creates a positive output gap, leading to inflationary pressures and a wage-price spiral.
What is the adjustment mechanism for a positive output gap?
- AD increases, causing SRAS to allow temporary production beyond 𝑌𝑛.
- Excess demand for labour and inputs creates shortages.
- Wages and input costs rise, shifting SRAS leftward.
- Real output returns to 𝑌𝑛 as inflation adjusts the economy to long-run equilibrium.
How do the Keynesian and Neoclassical LRAS curves differ?
Neoclassical: Vertical at 𝑌𝑛, markets are self-correcting with competitive full employment in the long run.
Keynesian:
* Horizontal section: Spare capacity; output increases without price level changes.
* Upward sloping section: Scarce resources cause rising output and price levels.
* Vertical section: Full employment reached; output is capped at 𝑌𝑛.
What does the Neoclassical LRAS curve emphasise?
Supply-side determinants like technological advancement, labour productivity, and market efficiency.
What is the Keynesian critique regarding the LRAS?
Demand-side failures can cause persistent underemployment, necessitating government intervention through fiscal policy.
What are the determinants of LRAS?
1. Quantity and Quality of Factors of Production:
Labour: Workforce size, skills, and productivity.
Capital: Infrastructure, technology, machinery.
Land: Natural resource availability.
Technological Progress: Increases productivity.
2. Institutional Factors: Market efficiency, legal frameworks.
3. Government Policies: Supply-side reforms, infrastructure investment
Provide examples of supply-side policies that influence LRAS.
Training programs, tax incentives for investment, deregulation, and spending on infrastructure.
What is a positive output gap?
When actual output exceeds potential output, causing inflationary pressures.
What is a negative output gap?
When actual output is below potential output, leading to unemployment and underutilised resources.
What is the wage-price spiral?
Rising wages increase production costs, causing inflation, which leads to further demands for higher wages.
How does the Phillips Curve relate to LRAS in the long run?
In the long run, there is no trade-off between unemployment and inflation, consistent with a vertical LRAS.
What evidence supports the Keynesian perspective on LRAS?
- Great Depression (1930s): Persistent underemployment despite falling prices.
- Post-2008 Financial Crisis: Demand-side policies reduced output gaps
What evidence supports the Neoclassical perspective on LRAS?
- Focus on supply-side policies (e.g., Reaganomics, Thatcherism) enhancing productivity and reducing inflationary pressures.
What are the policy implications of the Neoclassical and Keynesian LRAS views?
- Neoclassical: Structural reforms to shift LRAS outward.
- Keynesian: Demand-side interventions during underemployment
What dynamic factors cause LRAS to shift over time?
Changes in demographics, technological innovation, and education.
What are critiques of the Neoclassical and Keynesian approaches to LRAS?
- Neoclassical: Overestimates market efficiency.
- Keynesian: Risks crowding out private investment and increasing public debt.
What is hysteresis?
Prolonged downturns can reduce long-run potential output, causing the LRAS to shift left.
What is stagflation?
Simultaneous inflation and stagnation due to adverse supply shocks.
What does the Phillips curve describe?
A short-run trade-off between unemployment and inflation, linked to AD/AS dynamics.
What is the multiplier effect in fiscal policy?
Fiscal policy-induced AD changes amplify economic output through secondary spending cycles.
How do policies differ in their effectiveness based on SRAS?
- Horizontal SRAS: Expansionary policies are more effective in economies with spare capacity.
- Vertical SRAS: Such policies become inflationary under full capacity conditions.
Provide an example of a leftward SRAS shift.
The 1970s stagflation due to oil shocks.
Provide an example of AD-side policy focus.
The 2008 global financial crisis emphasized stimulus policies to combat demand deficiency.
