Module 5

Question 1

Aggregate Demand Curve

Answer 1

Shows the relationship between the overall price level and the level of total demand in the economy

On the graph, the price level is shown on the y-axis and the output (aggregate expenditure, GDP) is shown on the x-axis

Question 2

Effect of prices on components of output: Consumption

Answer 2

Increases in overall price levels decrease people’s wealth, and when people are less wealthy they consume less. This relationship is called the WEALTH EFFECT

NEGATIVELY RELATED

Question 3

Effect of prices on components of output: Investment

Answer 3

When prices rise, the interest rate also tends to rise which makes borrowing capital more expensive. When borrowing costs are high, firms invest less in new capital, resulting in an INDIRECT NEGATIVE RELATIONSHIP between price levels and investment

Question 4

Effect of prices on components of output: Government spending

Answer 4

Government spending remains constant regardless of price levels, so it does not contribute to the downward sloping nature of the aggregate demand curve

Question 5

Effect of prices on components of output: Net exports

Answer 5

When prices rise in Canada, demand will decrease because goods and services are more expensive. Thus, demand for imports increases and exports demand decreases which decreases net exports overall. There is a NEGATIVE RELATIONSHIP between price levels and net exports

Question 6

How does a change in overall price level affect Planned Aggregate Expenditure (PAE) curve?

Answer 6

Each price increase will result in a downward shift in the Planned Aggregate Expenditure curve

Each price decrease will result in an upward shift in the Planned Aggregate Expenditure curve

RECALL: the PAE curve is not the same as the Aggregate Expenditure curve

Question 7

Will a $500 million government spending package or a $500 million tax cut increase GDP more?

Answer 7

A $500 million government spending package will because $500 million will be automatically added to GDP and shift aggre

Question 8

Aggregate supply curve

Answer 8

Shows the relationship between the overall price level in the economy and the production of firms (output)

Question 9

Short run aggregate supply (SRAS)

Answer 9

The short run refers to the hourly, daily and weekly decisions that firms make. This can be the amount of hours that employees are scheduled to work or how much beef and lettuce to order for the week

Question 10

Short run aggregate supply (SRAS)

Answer 10

The short run refers to the hourly, daily and weekly decisions that firms make. This can be the amount of hours that employees are scheduled to work or how much beef and lettuce to order for the week

Question 11

Why does the SRAS slope upward?

Answer 11

In the short run, the aggregate supply curve slopes upward because firms increase their production when prices of final goods increase

This relationship exists because the prices of final goods and services tend to increase faster than the price of inputs. The slow adjustment of inputs is referred to as STICKY PRICES

Question 12

How long is the time period in Long Run Aggregate Supply Curve?

Answer 12

The long run is not a set amount of time (1 year, 2 years, 10 years), rather it takes however long until prices of inputs fully adjust to economic conditions

In macroeconomics we study how long it takes for the whole economy to adjust to prices, instead of just looking at quantities and fixed vs. variable costs

Question 13

Why is the Long Run Aggregate Supply Curve a vertical line?

Answer 13

Our model suggests that changes in prices of goods and services paid by consumers have no effect on the aggregate supply

The long run aggregate supply curve is a vertical line because the output supplied is the same at every price level

Question 14

What does the LRAS curve represent?

Answer 14

The long run aggregate supply curve represents the potential output in an economy–the level of output possible if the economy is operating at full capacity. It can be helpful to think of the long run supply curve as the production function–the production function shows how society’s natural resources can be combined to produce the greatest output

Question 15

How is the LRAS curve shifted left or right?

Answer 15

Changes in the long run aggregate supply are a result of a change in the way society’s resources create output.

Possibly a new technological invention or a discovery of new resources, like a new oil reserve. The steady push of the long run aggregate supply curve to the right–increasing potential output–is what drives economic growth

Question 16

What is one peak to another peak on a graph of an economy’s GDP?

Answer 16

One peak to another peak is considered one business cycle

Question 17

How can the SRAS curve be shifted?

Answer 17

Changes in inputs (production costs), supply shocks (good or bad)

Changes in anything but the price itself (which would generate a movement along the curve)

Question 18

Shifts in the Long Run Aggregate Supply

Answer 18

In the long run firms dictate the amount of output supplied by the availability of inputs, regardless of the overall price level

Recall that the LRAS curve is like a production function, a combination of technology, capital, labor and land to produce a certain amount of output.

New innovations in technology, new foreign investment capital, increased immigration, better education systems, and discovery of new resources would all increase potential output and shift the LRAS curve right

Question 19

Do the LRAS and SRAS curves always shift together?

Answer 19

No, there are situations where both curves shift together, but this doesn’t mean that they always do
Everything that shifts the LRAS curve will also shift the SRAS curve, but not the opposite

Question 20

How do expectations about higher future prices affect firms’ production?

Answer 20

Expectations about price changes affect firms production plans because they don’t want to get caught unaware by changes in input costs.

Future price hikes will also result in workers demanding higher wages, so firms prepare by reducing production at any given current price

Question 21

What does it mean when all three (LRAS, SRAS & AD) intersect?

Answer 21

The relationship between the intersection of LRAS, SRAS and AD says that prices are at expected levels and that short-run potential output is the same as long run potential output

Question 22

On the LRAS, SRAS & AD graph what does a rightward shift in AD do?

Answer 22

A rightward shift in AD would increase output and raise prices in the short run, but in the long run it would return to its original output level and the price would rise again

Question 23

What would a leftward shift in AD do on the LRAS, SRAS curve?

Answer 23

A leftward shift in AD would mean lower aggregate demand, which would cause lower output and prices in the short run, but in the long run it would return to original output with prices lowering again

Question 24

Does a supply shock affect the LRAS curve, SRAS curve or both?

Answer 24

Supply side shocks will affect only the SRAS curve if they are temporary, but they will affect both the SRAS and LRAS curve if they are permanent

Question 25

How does a temporary supply shock affect the economy?

Answer 25

When a temporary supply shock occurs, the SRAS curve will shift to the left, output will decrease and prices will rise. This economic state is also known as STAGFLATION where output is lagging behind and inflation occurs

Question 26

What are STICKY DOWNWARD prices?

Answer 26

This occurs often during stagflationary periods where input prices do not fall easily. Wages do not fall easily because employees are reluctant to accept lower income, causing prices to remain high for the economy and a persisting downward trend

Question 27

What happens to wages and unemployment when the economy is producing at less than potential output?

Answer 27

When the economy is producing at less than the potential output, firms lay off workers which increases the unemployment rate and wages inevitably fall. As production becomes cheaper, firms will start to increase their output

Question 28

What happens to the economy when there is a permanent supply shock?

Answer 28

When a permanent supply shock occurs, there is a loss in one of the factors of production which PERMANENTLY INCREASES PRICES and DECREASES OUTPUT

The LRAS curve will shift left, due to the loss in factors of production and the SRAS curve will shift left because of the higher prices and higher production costs

Question 29

Do the LRAS and SRAS shift simultaneously when there is a permanent supply shock?

Answer 29

No the SRAS curve and LRAS curve may not move simultaneously, and the SRAS curve may take a few shifts to reach the same level as the LRAS curve.

As long as prices are above the long run equilibrium level, the SRAS curve will continue to shift left until the economy reaches a new long run equilibrium

Question 30

How does Government spending to counteract negative demand shocks affect the economy?

Answer 30

Government spending will reduce the time of suffering (by allowing output to return to original levels sooner), and it will cause prices to go higher than original levels

Question 31

Keynesian view

Answer 31

This perspective believes that when the economy falls into a recessionary period, the government should intervene as much as possible because otherwise, the economy will destabilize after recovery

The same goes for inflationary periods, the Keynesian view advocates for monetary policy so that the economy doesn’t over-expand

Question 32

Classical economist view

Answer 32

Classical economists believe that there should be no government intervention during deviations from the natural output rate, as the economy is market-based

Question 33

Monetarist view

Answer 33

Argues for less government intervention than Keynesian view, but claims that there should be a mandate on the central bank to keep the money growth rate steady

Contends that this is the best way to promote growth without deliberate government action

Question 34

Q: When a non-price change affects any of the four components of GDP

Answer 34

A: the aggregate demand curve will shift left or right

Question 35

Q: When the economy produces less than its potential output, it is…

Answer 35

A: not in the long run equilibrium