L10 - The AD-AS Model Flashcards
What are the shift variables in the AD/AS Graph
Mark Up: µ
Unemployment Benefit: Z
Productivity: ɸ
Expected Prices: Pe
The main policy instruments affects only the demand curve
What are AD Shocks?
Sudden changes to aggregate demand.
DIAGRAM ON NOTES
What are AS Shocks?
Sudden changes to Aggregate Supply
DIAGRAM ON NOTES
What is the equation for the LRAS?
P = Pe (1+μ)f(Y/Φ, z)
Since, P=Pe in the LR then:
1/(1+μ) = f(Y/Φ, z)
Rearranging in terms of Y* =
Y*= F(Φ, μ, z)
Where, Y* is the full employment level of output.
Hence, LRAS shifts to right as:
Φ rises; μ falls; and z falls
Why is the LRAS vertical in Long Run?
As the forces of supply and demand always move back to the same level at any point.
(Automatically self-adjust back to equilibrium)
If takes too long prompting Govt intervention
SEE DIAGRAM ON NOTES
What is a Recessionary/Deflationary Gap?
Actual GDP lower than potential (LRAS Curve)
SEE DIAGRAM IN NOTES
What is a Inflationary Gap?
Real GDP greater than potential GDP
SEE DIAGRAM IN NOTES
What is Automatic Adjustment?
Prices are in general slower to fall than they are to rise
So, easier to fulfil an inflationary gap may be eliminated quickly by rising prices and unit labour costs, a recessionary (or deflationary) gap may never be eliminated by wage and price adjustment – justifies policy interventions
What may cause a recessionary gap?
- Under-performing economy
- Lack of Demand
- Below full employment
- Falling Prices
- Unused Resources
- Higher than normal unemployment
What may cause a Inflationary Gap?
- Over-performing economy
- High demand
- Demand Pull Inflation
- Above full employment
- Rising Prices
- Unsustainable Output
- Lower than normal unemployment
What can help alleviate low demand?
Mainly Demand side policies
- Shift to right can help in SR. But if policy overshoots have to deal with inflationary gap (Y2,AD2)
- Permanent increase in GDP can only happen if it is caused by a rise in productivity (Φ), or a permanent cut in unemployment benefit (z) or the mark-up (µ). In these cases both SRAS and LRAS shift to the right
DIAGRAM ON NOTES
What are the three big policy dilemma’s facing the UK in recent times?
- The oil price shocks 1973-4 & 1979-80
- ERM Membership 1990-92
- The Global financial crash 2008-09
What were the responses to the Oil Shock?
Option 1:
When faced with 1973-74 oil price shock Labour Govt. at the time decided to deal with this by increasing AD0 to AD1. Thus, causing inflation to P3 but protecting workers
Option 2:
When again faced with 1979-1980 oil price shock Thatcher govt. decided to decrease AD0 to AD2. Thus, keeping inflation low but at the cost of increase unemployment (Y2)
Option 3:
Do nothing wait until unemployment puts downward pressure on money wages and price expectations so SRAS1 moves back to SRAS0
SEE DIAGRAM ON NOTES
What were the responses to the ERM/EMS Membership Shock?
Option 1:
Take a hit on unemployment and wait until in the long run wage and price expectations adjust downwards – restoring output back to its equilibrium level (Conservative Party policy 1990-92)
Option 2:
Admit policy mistake and devalue £ against other EMS currencies
Option 3:
Wait for a speculative attack to destroy the credibility of the fixed rate policy, forcing the £ out of the system and bring about a 14% devaluation of the £ and shift AD curve back to the right (What happened in September 1992)
SEE DIAGRAM ON NOTES
What were the responses to the Global Financial Crisis?
ECB option:
Cut demand to point C to prevent inflation but cause huge deflation and unemployment. Nationalise or bail out private banks bankrupting governments, but maintaining the payments system.
Quantitative Easing:
Rekindle demand in economy. Try to repair banks balance sheets so reducing the need for public sector cuts
Option 3: As option 2 but with a fiscal deficit enlargement to protect employment and actively stimulate economic growth (Nobel prize winners – Krugman and Stiglitz)
SEE DIAGRAM ON NOTES
