EC SECOND TEST STUDY GUIDE

Question 1

Why is SAS upward-sloping

Answer 1

Money wages and prices of other resources are assumed to be constant in the short- run.
This implies that higher prices will lead to higher output and higher profit.

Question 2

Why is LAS vertical?

Answer 2

money wage and price level change proportionately, employment is always at full-employment and regardless of how price level changes, potential GDP does not change

Question 3

Factors that shift SAS and LAS

Answer 3

An increase in potential GDP will shift both LAS and SAS to the right. A decrease in potential GDP will shift both to the left.
Change in money wage or prices of other factors will shift SAS.
An increase in money wage or prices of other factors such as oil will decrease SAS and shift SAS to the left.

Question 4

Explain the wealth effect.

Answer 4

As price increases, real wealth decreases.
To restore real wealth people save more and consume less.
As price decreases AD increases (AD is an inverse relation between price level and real GDP.)

Question 5

Explain the substitution effect.

Answer 5

-as price increases, domestic goods become more expensive relative to foreign goods.
-people will substitute foreign goods for domestic goods.
-increase in import and a decrease in AD.
-as price decreases, people substitute domestic goods for foreign goods.
-Import decreases and AD increases