Lec 4 - Aggregate Supply & Aggregate Demand

Question 1

Quantity of real GDP supplied definition

Answer 1

The total quantity that firms plan to produce during a given period.

Question 2

Aggregate supply definition

Answer 2

The relationship between the quantity of real GDP supplied and the price level.

Question 3

Macroeconomic long run definition

Answer 3

A time frame that is sufficiently long for all adjustments to be made so that real GDP equals potential GDP and full employment prevails.

Question 4

Long run aggregate supply definition

Answer 4

The relationship between the quantity of real GDP supplied and the price level when the money wage rate changes in step with the price level to maintain full employment.

Question 5

Long run aggregate supply curve

Answer 5

The quantity of real GDP supplied at full employment equals potential GDP and this quantity is independent of the price level. So, the long-run aggregate supply curve (LAS) is vertical at potential GDP.
In the long run, the quantity of real GDP supplied is potential GDP: as the price level rises and the money wage rate changes by the same percentage, the quantity of real GDP supplied remains at potential GDP.

Question 6

Short run aggregate supply definition

Answer 6

The relationship between the quantity of real GDP supplied and the price level when the money wage rate, the prices of other resources and potential GDP remain constant.

Question 7

Short run aggregate supply curve

Answer 7

The short run aggregate supply curve (SAS) is upward sloping.
A rise in the price level with no change in the money wage rate induces firms to increase production which increases the quantity of real GDP supplied.

Question 8

Changes in aggregate supply

What causes a change in aggregate supply?

Answer 8

Aggregate supply changes if an influence on production plans other than the price level changes:
• Changes in potential GDP: an increase shifts both LAS and SAS rightward.
o An increase in the full-employment quantity of labour
o An increase in the quantity of capital (physical or human)
o An advance in technology
• Changes in other input prices (including money wage rate): only SAS curve shifts.

Question 9

Sticky wages

Answer 9

Wages have a tendency to get “stuck” and not adjust downwards.
This occurs even during a recession, when falling wages would help end the recession more quickly.
Wage cuts cause low employee morale.
Money Illusion (nominal wage cut vs inflation).
Wages fall slowly during a recession; price inflation might be good in a recession.

Question 10

Aggregate demand equation

Answer 10

The quantity of real GDP demanded (Y), is the total amount of final goods and services produced in the UK that governments (G), foreigners (X – M) people and businesses (C) plan to buy.
Y = C + I + G + X – M

AKA aggregate expenditure.

Question 11

Influences on buying plans

What are the four main influences on buying plans?

Answer 11

• The price level
• Expectations
• Fiscal and monetary policy
• The world economy

Question 12

Aggregate demand definition

Answer 12

The relationship between the quantity of real GDP demanded and the price level.

Question 13

Aggregate demand curve

Answer 13

The AD curve slopes downward for two reasons:
• Wealth effect: A rise in the price level, other things remaining the same, decreases the quantity of real wealth. To restore their real wealth, people increase saving and decrease spending, so the quantity of real GDP demanded decreases.
• Substitution effects
o Interest rate effect: A rise in the price level, ceteris paribus, decreases the real value of money and raises the interest rate. When the interest rate rises, people borrow and spend less, so the quantity of real GDP demanded decreases.
o Exchange rate effect: A rise in the price level, ceteris paribus, increases the price of domestic goods relative to foreign goods, so imports increase and exports decrease, which decreases the quantity of real GDP demanded.

Question 14

Aggregate demand and expectations

What are the three factors which influence AD?

Answer 14

Expectations about future income, future inflation and future profits shift aggregate demand:
• Increases in expected future income increase people’s consumption today and increases aggregate demand.
• A rise in the expected inflation rate makes buying goods cheaper today and increases aggregate demand.
• An increase in expected future profits boosts firms’ investment, which increases aggregate demand.

Question 15

Aggregate demand and fiscal policy

Answer 15

Fiscal policy (taxes, transfer payments, and G):
• A tax cut or increase in transfer payments increases households’ disposable income: increases consumption expenditure (C) and aggregate demand.
• An increase in government expenditure (G): increases AD.

Question 16

Aggregate demand and monetary policy

Answer 16

Monetary policy (interest rates and the quantity of money):
•	An increase in the quantity of money: increases buying power and increases aggregate demand.
•	A cut in interest rates: increases expenditure and increases aggregate demand.

Question 17

Aggregate demand and world economy

In what two ways does world economy influence AD?

Answer 17

The world economy influences aggregate demand in two ways:
• A fall in the foreign exchange rate: lowers the price of domestic goods and services relative to foreign goods and services, increases exports, decreases imports, and increases aggregate demand.
• An increase in foreign income: increases the demand for UK exports and increases aggregate demand.

Question 18

Short run macroeconomic equilibrium

Answer 18

Short-run macroeconomic equilibrium occurs at the point of intersection of the AD curve and the SAS curve.
If real GDP is below equilibrium GDP, firms increase production and raise prices and if real GDP is above equilibrium GDP, firms decrease production and lower prices.
These changes bring a movement along the SAS curve towards equilibrium.
In short-run equilibrium, real GDP can be greater than or less than potential GDP.

Question 19

Long run macroeconomic equilibrium

Answer 19

Long-run macroeconomic equilibrium occurs when real GDP equals potential GDP − when the economy is on its LAS curve, at the intersection of the AD and LAS curves.
Long-run equilibrium occurs when the money wage has adjusted to put the SAS curve through the long-run equilibrium point.
At the long-run equilibrium money wage rate, there is neither a shortage nor a surplus of labour and the money wage rate remains constant.

Question 20

Economic growth in AS-AD model

Answer 20

As a result of the increasing quantity of labour, capital is accumulated and technology advances, potential GDP increases.
The LAS curve shifts rightward.

Question 21

Inflation in AS-AD model

Answer 21

If the quantity of money grows faster than potential GDP, aggregate demand increases by more than long-run aggregate supply.
The AD curve shifts rightward faster than the rightward shift of the LAS curve.

Question 22

The business cycle in AS-AD model

Answer 22

The business cycle occurs because aggregate demand and the short-run aggregate supply fluctuate, but the money wage does not change rapidly enough to keep real GDP at potential GDP.
A full-employment equilibrium: an equilibrium in which real GDP equals potential GDP.
An above full-employment equilibrium: an equilibrium in which real GDP exceeds potential GDP.
The amount by which real GDP exceeds potential GDP is called an output gap.
When real GDP exceeds potential GDP, the output gap is called an inflationary gap.

Question 23

Fluctuations in AD

What does an increase in AD do?

Answer 23

An increase in aggregate demand shifts the AD curve rightward.
The price level rises and firms increase production in the short run.
At the short-run equilibrium, there is an inflationary gap.
The money wage rate begins to rise and the SAS curve starts to shift leftward.
The price level continues to rise and real GDP continues to decrease until the economy has returned to full-employment.

Question 24

Fluctuations in AS

What effect would a rise in the price of oil have?

Answer 24

The effects of a rise in the price of oil:
Short-run aggregate supply decreases and the SAS curve shifts leftward.
Real GDP decreases and the price level rises.
The economy experiences stagflation.

Question 25

Macroeconomic schools of thought

Answer 25

• The Classical view
• The Keynesian view
• The Monetarist view

Question 26

Macroeconomic schools of thought - The Classical view

Answer 26

The economy is self-regulating and always at full employment.
A new classical view is that business cycle fluctuations are the efficient responses of a well-functioning market economy to shocks arising from the uneven pace of technological change.

Question 27

Macroeconomic schools of thought - The Keynesian view

Answer 27

Left alone, the economy would rarely operate at full employment and active help from fiscal policy and monetary policy is required.
A new Keynesian view is that not only is the money wage rate sticky but also are the prices of goods sticky.

Question 28

Macroeconomic schools of thought - The Monetarist view

Answer 28

The economy is self-regulating and that it will normally operate at full employment, provided that the pace of money growth is kept steady.