Aggregate-demand and supply, textbook info Flashcards
What is the context of understanding this chapter?
We want to look at the behaviour of inflation. To reduce inflation, we need to drive the economy into a recession (contractionary gap). This chapter tries to balance the two by extending the keynesian model (which is only short).
What does an aggregate demand curve show?
- Shows the relationship between rate of inflation (Pi) vs equilibrium output (Y)
- It also shows the relationship between inflation and planned spending because Y=PAE in the short-run.
Why is the aggregate demand curve downward sloping?
We see that as inflation increases, output decreases essentially.
What implications do the reserve bank’s anti-inflation policies have for the slope of the aggregate demand curve?
The RBA aims for an inflation rate of around 2-3%.
To do this, they control equilibrium output by increasing real interest rate, which reduces exogenous (not directly related to Y) expenditure (consumption and investment), hence reducing equilibrium output.
Thus, higher inflation causes a reactionary policy by the RBA to reduce equilbrium output, meaning that as output increases (expansionary output gap), inflation decreases..
What is a simple reason for inflation to occur?
Typically, higher inflation rates occur when firms produce above their potential output (expansionary output gap) - leading to price increases with increased demand.
What is the effect of inflation on the real value of net assets (wealth) held by households and businesses?
It causes for the downward slope of the AD curve by reducing the real value of money. Because people’s purchasing power is lowered in times of high inflation, they withhold from spending. This reduces equilibrium output (Y).
What are distributional effects?
Another channel for AD to be downward sloping. Less affluent people tend to spend a larger portion of their wealth compared to wealthy people. However this causes for redistribution of resources towards affluent people, who tend to spend less of their portions of wealthy, reducing overall spending.
How does uncertainty for households and businesses affect the AD curve?
It is a channel for which AD curve is downward sloping, as people are more cautious with their spending and there’s less spending overall.
How does inflation relate the AD curve to prices of domestic goods and services sold abroad?
Causes for AD to be downward sloping, as net export sales decreases, reducing PAE, and hence equilibrium output.
Summarise the 4 other factors in which inflation causes for the AD curve to be downward sloping.
- Real value of money decreases, causes for less spending.
- Redistributes economic resources from less affluent households to affluent households as the former spends more and the latter spends less (proportionally),
- Uncertainty - when you don’t know how the prices of things will turn out, you become more cautious in your spending (thus less).
- Prices of domestic goods increases and hence less X in PAE, lowering PAE=Y.
For what reasons might the AD curve shift?
The AD curve shifts based on two things:
- exogenous expenditure
- changes in RBA’s monetary policy
How does exogenous expenditure shift the AD curve?
When exogenous spending increases (referring to factors other than output and interest rate), output is increased at each level of inflation and thus the AD curve shifts to the right.
Similarly, decline in exogenous spending shifts the AD curve to the left (PAE decreases, equilibrium Y decreases).
When do exogenous changes in the RBA’s policy reaction occur?
Normally the RBA’s monetary policies doesn’t shift the AD curve for stability. However, in times where inflation is particularly high for an extended period, the RBA becomes tighter and increases real interest rate at every level, shifting curve leftwards.
In times where a recession has remained for an extended period causes for more decrease in real interest rate than usual at every level, shifting curve rightwards.
For what reasons might the aggregate demand curve shift?
Exogenous changes mainly. The point of this question is distinguishing movement along the curve, and shifts in the curve. In particular, no changes in the RBA’s reaction function means that movement along the curve just means how inflation is related to demand.
For what reason might the economy move along the aggregate demand curve?
Changes in the inflation rate and hence changes in real interest rate and equilibrium output represents movement along the demand curve.
Kinda obvious if you think about, inflation makes RBA react in such a way so that demand decreases with higher prices (via real interest rate). Only exceptional circumstances causes for exogenous changes to reaction function causes shifts.
