L8 - Aggregate Demand

Question 1

What causes AE to shift?

Answer 1

• Price

- Net Exports

Question 2

What is Keynes view on Consumption?

Answer 2

Consumption depends on level of disposable income

Question 3

What is Friedman’s and Modigliani’s view on consumption?

Answer 3

Friedman’s permanent income hypothesis

Modligliani’s life time income (spending changes based on age)

Question 4

What is the link between changes in private consumption and the price level?

Answer 4

The link between these changes is Non-bank private sector (NBPS) wealth

Question 5

What is NBPS wealth?

Answer 5

NBPS Wealth consists of cash,bank deposits and bonds which are denominated in money terms

Question 6

What is wealth denoted as?

Answer 6

A

That’s it

Question 7

What happens to real wealth as prices rise?

Answer 7

Real Wealth falls

As measured by A/P
Rise in prices reduce real value of assets

Question 8

What is Insider Wealth?

Answer 8

• Some nbps wealth is inside wealth; i.e. an asset issued by an agent in the private sector (say a firm) and held by another agent (say a household) in the same sector.

• Rise in P raises the real wealth of the bond-issuer, who will have to part with less purchasing power when the bond is redeemed;
• Lowers the real value to the bond holder who receives less in real terms on redemption
• If both issuer and holder are in the same (private) sector then the effect on nbps wealth is zero

Question 9

What is Outsider Wealth?

Answer 9

• Outside wealth is where assets are held by agents in private sector of the domestic economy but issued by those from outside that sector i.e Government sector or overseas sector
• no offsetting within-sector effects, so a rise in P does reduce the real outside wealth of the nbps

Assume all NBPS Wealth to be Outside wealth

Question 10

What is the modified consumption function including the real wealth ratio (A/P)

Answer 10

C=f(Yd,A/P)

Question 11

What happens if P rises within the Income Expenditure diagram?

Answer 11

As P rises, for a given stock of nominal outside wealth (A), real wealth will fall and C will fall, which will lead to a fall in the AE-line.

SHOWN IN DIAGRAM

Question 12

What happens if P falls within the Income Expenditure Diagram?

Answer 12

As P falls, for a given A, (A/P) will rise and C will rise, shifting the AE-line upwards.

Question 13

How can Net Exports shift AE?

Answer 13

 When the domestic price level (P) falls, domestically produced goods become cheaper compared to foreign goods, whose prices (P*) are assumed to be unchanged

 Change in relative prices causes domestic consumers to increase their purchases of domestically produced goods and to reduce their purchases of foreign goods (assuming a constant exchange rate)

 Leads to both the NX-line and the AE-line shifting up

SHOWN IN DIAGRAM

Question 14

What is the total effect of a change in P on AE?

Answer 14

 The total effect of a rise (fall) in P on AE is to reduce (raise) consumption via the fall (rise) in nbps outside wealth and to reduce (increase) NX as domestic competitiveness declines (improves)

 Both of these effects operate in the same direction and so a rise (fall) in P leads to a fall (rise) in AE and a shift down (up) in the desired expenditure schedule, from AE0 to AE1

Question 15

How do you derive the AD Diagram?

Answer 15

The summing of points of the equilibrium on the AE line.

DIAGRAM ON NOTES

Question 16

What does it mean if there are points to the left of the Aggregate Demand Curve?

Answer 16

Points to the left of the AD curve show combinations of P and GDP where AE>Y;

thus there is pressure on Y to rise because firms could sell more than current
output

DIAGRAM ON NOTES

Question 17

What does it mean if there are points to the right of the Aggregate Demand Curve?

Answer 17

Points to the right of AD show combinations of P and GDP where AE

Question 18

What are shifts in AD caused by?

Answer 18

caused by changes in any variables other than P, that shift the AE-line

i.e. autonomous consumption (a), taxation (t0), net exports (x0), or investment (I), government spending (G), the rate of interest (r), the exchange rate or foreign price level (P*E)

Any variable which shifts AE up, will shift AD to the right; and any variable which shifts AE down, will shift AD to the left

Question 19

How does AD and the Multiplier interact?

Answer 19

 multiplier measures the magnitude of the change in ‘equilibrium’ GDP in response to a change in autonomous spending at a given price level

 context of the AD-curve this same magnitude is measured by the horizontal shift of the AD curve

Just causes shifts in AD

DIAGRAM ON NOTES

Question 20

What is Aggregate Supply?

Answer 20

Total output of goods and services that firms wish to produce, assuming they can sell all they wish to sell at the going price level.

Question 21

What is SRAS?

Answer 21

SRAS shows desired quantity firms wish to produce based on assumption all input prices remain constant

Question 22

What is LRAS?

Answer 22

LRAS is the desired quantity firms wish to produce after price level and input prices fully adjusted to any demand shock

Question 23

What are the factors determining AS?

Answer 23

Output prices,

• wage rates,
• other input costs, such as oil and raw materials
• productivity of labour
• Wage costs will depend, in part, on the general level of employment

Question 24

What does the slope of the AS curve depend on?

Answer 24

• How production costs are related to output

- How goods prices and output are related

Question 25

What’s the Problem of Supply and Demand Analysis?

Answer 25

Labour market NOT a perfectly competitive market, but rather a market where bargaining takes place. Thus the standard demand and supply framework is not an appropriate tool of analysis.