Chapter 10: Aggregate Demand and Aggregate Supply Analysis Flashcards
What is the aggregate demand and supply model?
A model that explains short-run fluctuations in real GDP and the price level. The price level and real GDP are determined in the short run by the intersection of the AD curve and the AS curve.
What is the aggregate demand (AD) curve?
A curve that shows the relationship between the price level and the quantity of real GDP demanded by households, firms and the government, plus net exports.
What is the short-run aggregate supply (SRAS) curve?
A curve that shows the relationship in the short run between the price level and the quantity of real GDP that would be supplied at each price level.
Why is the aggregate demand curve downward sloping?
The AD curve is downward sloping because a fall in the price level increases the quantity of real GDP demanded.
Explain the wealth effect: a change in the price level affects consumption
Current income is the most important variable determining the consumption of households. As income rises, consumption will rise, and as income falls, consumption will fall. But consumption also depends on household wealth.
When the price level rises, the real value of household wealth declines, and so will consumption. When the price level falls, the real value of household wealth rises, and so will consumption. This impact of the price level on consumption is called the wealth effect, and is one reason why the AD curve is downward sloping.
Explain the interest rate effect: how a change in the price level affects investment
When prices rise, households and firms need more funds to finance buying and selling. Therefore, when the price level rises, households and firms try to increase the amount of funds they hold by withdrawing savings from banks, borrowing from banks or selling financial assets, such as bonds. These actions tend to drive up the interest rate charged on bank loans and the interest rate on bonds.
A higher interest rate raises the cost of borrowing for firms and households. As a result, firms will borrow less to build new factories or to install new machinery and equipment, and households will borrow less to buy new houses.
To a smaller extent, consumption will also fall as households borrow less to finance spending on cars, furniture and other durable goods.
Explain the international-trade effect: how a change in the price level affects net exports
Net exports equals spending by foreign households, firms and governments on goods and services produced in Australia minus spending by Australian households, firms and governments on goods and services produced in other countries.
If the price level in Australia rises relative to the price levels in other countries, Australian exports will become relatively less profitable to produce compared with those produced for the domestic market, and foreign imports will become relatively less expensive.
Some consumer in foreign countries will shift from buying Australian products to buying domestic products. Some Australian firms will also shift from producing export goods to producing goods for the Australian market. Australian imports will rise and export earning will falls, causing net exports to fall.
What variables shift the aggregate demand curve?
- Changes in government policies
- Changes in the expectation of households and firms
- Changes in foreign variables
Explain the following variable that shifts the AD curve: changes in government policies
Monetary policy involves RBA actions to changes interest rates. Lower interest rates lower the cost to firms and households of borrowing. Lower borrowing costs should usually increase consumption and investment spending, which shifts the AD curve to the right. Higher interest rates shift the AD curve to the left.
Fiscal policy involves changes in federal government purchases and taxes that are intended to achieve macroeconomic objectives, such as high employment, price stability and healthy rates of economic growth.
- Increase in government purchases = AD curve shifts to right
- Decrease in government purchases = AD curve shifts to left
- Increase in individual income taxes = AD curve shift to left
- Decrease in individual income taxes = AD curve shift to right
- Increase in company income taxes = AD curve shift to left
- Decrease in company income taxes = AD curve shift to right
Explain the following variable that shifts the AD curve: changes in expectations of households and firms
If households become more optimistic about their future incomes, they are likely to increase their current consumption. This increase consumption will shift the AD curve to the right. If households become more pessimistic about their future incomes, the AD curve will shift to the left.
Similarly, if firms become more optimistic about the future profitability of investment spending, the AD curve will shift to the right, and if firms become more pessimistic, the AD curve will shift to the left.
Explain the following variable that shifts the AD curve: changes in foreign variables
If firms, households and governments in other countries buy fewer Australian goods or if firms, households and government in Australia buy more foreign goods, net exports will fall and the AD curve will shift to the left.
If real GDP in Australia increases faster than real GDP in other countries, Australian imports will increase faster than Australian exports and net exports will fall. Net exports will also fall if the exchange rate between the dollar and foreign currencies rises, because the price in foreign currency of some Australian products, such as education services, sold in other countries will rise, and the dollar price of foreign products sold in Australia will fall.
What is the long-run aggregate supply (LRAS) curve?
A curve that shows the relationship in the long-run between the price level and the quantity of rea GDP that can be supplied when all firms are producing at normal capacity. The LRAS curve is a straight vertical line because aggregate supply is not affected by changes in the price level in the long run.
What factors shift short-run and long-run aggregate supply?
Shifts occur over time due to potential GDP increases each year, this can be due to:
- An increase in resources, such as migrant workers or new mineral discoveries in the economy
- An increase in the quantity of machinery and equipment used in production
- New technology or more productive ways of using resources
What does the SRAS curve look like?
It is upward sloping, this is because, over the short-run, as the price level increases, the quantity of goods and services firms are willing to supply will increase.
The main reason firms are willing to supply more gods and services as the price level rises is that a prices of final goods and services rise, prices of inputs (such as wages of workers or the price of natural resources) rise more slowly.
Profits rise when the prices of the goods and services firms sell rise more rapidly than the prices they pay for inputs. Therefore, a higher price level leads to higher profits and increases the willingness of firms to supply more goods and services.
A secondary reason the SRAS curve slopes upward is that, as the price level rises or falls, some firms are slow to adjust their prices.
What are some common explanations regarding the shape of the SRAS curve?
- Contracts make some wages and prices ‘sticky’
- Firms are often slow to adjust wages
- Menu costs make some prices sticky
