putting together aggregate supply and demand

Question 1

what is the formula for aggregate supply?

Answer 1

P = Pe + b(Y - Y) where P is the price level , Y is real income and Y is the potential income and Pe is expected price level

Question 2

why does the AS curve have a positive slope in a price-income diagram when there is an unexpected price rise?

Answer 2

this is due to the fact that when the price rises unexpectedly, firms will extend their production beyond the normal level. this is because once nominal wages are fixed by a collective contract, a higher price will mean a lower real wage W/P. at a lower real wage, firms will demand more labour and so output will be increased

Question 3

why is the approximation of the AS curve as a linear curve not accurate?

Answer 3

it is only accurate when it is in the neighbourhood of the current level of prices. the further you move away the less accurate it becomes. the linear relationship can be proven to be flaud by the fact that an increase from 1 to 2 raises aggregate output just as much as a rise from 100 to 101. this does not make sense as in the first case real wages fall by half but in the second they fall by meagre 1%. the more reasonable approximation would be a non linear relationship where the same percentage drop in the real wage should always trigger the same output response.

Question 4

what is a formula for a non linear AS curve?

Answer 4

p=pe + b(Y-Y*) where p =ln(P)

Question 5

what is the AS curve?

Answer 5

it shows what firms are willing to produce at different price levels. they will do so only if sufficient demand is there

Question 6

what augments the AS curve?

Answer 6

the AS curve will only produce the level of the goods when there is sufficient demand so therefore the supply demand decisions reflected in the AS curve must be augmented by the information about the economy demand side

Question 7

what does the term demand side equillibrium refer to?

Answer 7

it refers to the income level at which the economy would be in equilibrium provided that firms supply all goods and services that are being demanded

Question 8

in what situation are the assumptions about the Mundell-Fleming model acceptable?

Answer 8

it is only acceptable in the very short run or in situations of severe capacity utilisation

Question 9

what is a formula for the AD curve?

Answer 9

P = a- bY + other factors

Question 10

how can you derive the AD curve from the LM-FE-IS curve model?

Answer 10

assume an economy is intially at equillbrium at income Y and price level P. in flexible exchange rates the income is determined by equilibrium in the money market (LM) and in the foreign exchange market (FE) alone. the real exchange rate will change endogenously to make the IS curve intersect at the same point. if we assume that exogenous variables that affect LM and FE are unchanged then an increase in the price level reduces the real money supply and thus shifts LM up . this moves the intersection of FE and LM to the left thus lowering the equilibrium income. there will also be an accompanying appreciation driving down net exports moving IS left. when prices are low income is higher

Question 11

what are the other factors that affect AD under a flexible exchange rate?

Answer 11

those that affect the postions of the FE and LM curve. the LM curve only shifts due to changes in the real money supply. the FE curve is determined by two factors; the world interest rate and the expected depreciation.

Question 12

how can you write the AD curve under a flexible exchange rate?

Answer 12

P = a - bY + other factors [ M(+) , iworld(+), expected depreciation (+)

Question 13

what occurs to the AD curve when there is a rise in the expected depreciation?

Answer 13

a rise in the expected depreciation will shift the foreign exchange market line up which will move the macroeconomic equillbrium up and to the right along the LM curve raising income. as the price level will have remained the same this implies that there is a shift of AD to the right

Question 14

what occurs to the AD curve when there is a rise in the money supply under a flexible exchange rate?

Answer 14

an increase in the nominal money supply will shift LM curve to the right raising the income at any given price level hence if the M rises then the AD curve shifts to the right

Question 15

what occurs tp the AD curve when there is a rise in the world interest rate under a flexible exchange rate?

Answer 15

a rise in the world interest rate will shift the foreign exchange market line up whcih will move the marcoeconomic equillibrium up and to the right along the LM curve raising income, as the price level remained the same this implies that there is a shift of the AD curve to the right

Question 16

how can you derive the AD curve under a fixed exchange rate?

Answer 16

income is determined by the intersection betweent he FE and the IS curve under a fixed exchange rate. the LM curve becomes redundant because the money supply must adjust to make LM pass through where FE and IS cross. as prices rise, the real exchange rate will depreciate R= E xPworld/P ( ie falls). this will depress net exports shifting the iS curve to the left. equillbrium income will then fall so again there will be a negatively sloped AD curve

Question 17

what is the equation for the AD curve under a fixed exchange ratw?

Answer 17

P = a -bY + other factors [ E(+), Pworld(+), G(+), Yworld (+), iworld(-), expected depreciation(-)

Question 18

when exhange rates are fixed what are the other factors that affect AD curve?

Answer 18

the other factprs are those that affect the IS and the FE curves. for the FE curve what affects the postion is the world interest rate and the expected depreciation which both shift the FE curve line up. what affects the IS curve is all factors that affect the demand for goods and services such as government expenditure, world income, the exchange rate and the world price level. if taxes fall or any other variable rises then the IS curve will shift right raising the income.

Question 19

what is the equation for the non linear AD curve under a flexible exchange rate?

Answer 19

p = m - bY + h(iworld + expected depreciation) where p = ln(P) and m = ln(M)

Question 20

what is the non linear AD curve under a fixed exchange rate?

Answer 20

p = e +pworld - bY + dYworld + fG - h(iworld +expected depreciation) where e is log of exchange rate, pworld is log of Pworld and p is log of Pricelevel

Question 21

why does the exchange rate and the world prices need to be entered as a logarithm under a fixed exchange rate?

Answer 21

you need to enter them as logarithms as it ensures that a same percentage change of the real exchange rate always has the same effect on the aggregate demand

Question 22

why does the money supply need to entered as a logarithm under a flexible exchange rate>

Answer 22

it needs to be entered as a logarithm to ensure that the change in the real money supply is required to move the curve

Question 23

under a flexible exchange rate what does the AS-AD model read?

Answer 23

p=m- bY + h(iworld + expected depreciation) = pexpected + g(Y-Yexpected)

Question 24

what occurs to the AS curve when the expected price level rises

Answer 24

when the expected price level rises , trade unions will demand higher wages and induce firms to produce less output at any given price level.

Question 25

what occurs to the AS curve when there is a rise in the price level?

Answer 25

as we move up on a given AS curve the real wage declines which makes labour cheaper therefore incentives firms into hiring more labour and producing more output

Question 26

what is the equation of the long run AS curve?

Answer 26

Y=Y* where Y* is potential income

Question 27

why is the LRAS curve a vertical line

Answer 27

it is a vertical line becuase eventually the actors involved will learn and raise the expected prices towards to the actual prices. when you set p=pe then solving for Y gives you Y=Y*

Question 28

what is the equillibrium price level?

Answer 28

the price level at which the aggregate demand and aggregate supply intersect

Question 29

what is the short run equillbrium price level?

Answer 29

the price level at which aggregate demand and short run aggregate supply intersect

Question 30

what is the long run equillibrium price level?

Answer 30

the price level at which the aggregate demand and the long run aggregate supply intersect

Question 31

what markets are in equillibrium at the long run equillbrium price level and why?

Answer 31

the goods market, the money market, the foreign exchange market and the labour market. this is due to the fact that every point on the AD curve has an equillibrium in the goods, money and foreign exchange market and every point on the LRAS has labour market in equillibrium ( this is because the plans and expectations of both employers and trade unions have worked out?

Question 32

what markets are in equillibrium at the short run equillbirium price and why?

Answer 32

all three markets on the demand side of the model economy is in equilibrium (goods market, money market. foreign exchange market) however the short run AS curve only represents a short temporary equilibrium in the labour market as its only the employers plans that work out but not the unions plans as wages are lower then trade unions aim. however the unions are stuck with this wage until contracts run out where they will negotiate a new wage

Question 33

what is the link between short run equilibrium and long run equilibrium?

Answer 33

it is the ability for trade unions to learn from and correct expectations errors. it will be a system of changing the wage contracts until the SRAS and the LRAS and the AD curve all intersect at the same point

Question 34

what is the effect of an increase in government spending under a flexible exchange rate on the AD AS model?

Answer 34

it cannot shift the AD curve as fiscal policy is only effective under fixed exchange rates. an increase in government spending will just lead to crowding out of net exports by making the exchange rate increase. therefore although AD hasn’t shifted it has changed the composition of AD. income does not change, tax doesn’t change because it is dependent on income. investment does not change as that depends on interest rate which doesn’t change. the government budget surplus will detoriate as G increases. as C and I remain unchanged, an increase in government expenditure must cause a decrease in net exports. as income is fixed, net imports can only change in exchange rate appreciates

Question 35

what is the effect of an increased government spending under a fixed exchange rate on the AD-AS model?

Answer 35

assuming the economy is orginally at long run equillbrium at P0 and Y* for a while so expected prices equal actual prices (SRAS =LRAS=AD). if the government decides to increase spending that has not been anticipated by the wage contracts then the SRAS curve will stay put whilst the AD curve shifts to the right due to a rise in G. the increase in government spending has then increased AD at all price levels. at the current price level, supply will not produce more than Y*. therefore there will be excess demand, causing the prices to rise. on the supply side when the nominal wage is fixed, the real wages will therefore fall and so firms will hire more workers to produce output. this will begin to move along the short run supply curve. with rising prices, the demand for domestic goods begins to fall as imports become relatively cheaper. this will occur until the SRAS and the AD curve meet at which there will be a new temporary equilibrium at a higher price level and greater income. at the end of the period when contracts are ended, then new wages will be negotiated. the new contracts will be continued to be negotiated until SRAS curve intersects the AD curve on the LRAS curve.

Question 36

what are adaptive expectations?

Answer 36

adaptive expectations are formed on the basis of the recent history of the variable under consideration alone. expectations adapt to what the variable did in the past. they are driven by the general equation
Pexpected = P(expected the period before) + a ( P (period before) - P (expected the period before))
where a is how quickly expected prices adapt to actual prices

Question 37

what is the effect of monetary policy on the AD AS model when the exchange rates are flexible?

Answer 37

in period 0, the economy is in the long run equilibrium. in period 1, the central bank expands the money supply, shifting the LM curve in the mundell flemming frame to the right. this will put pressure downward on the interest rate makes the exchange rate depreciate and therefore the aggregate expenditure curve in the keynsian cross will shift up and the AS line shift to the right. these curves are not affected by the money supply itself but by the exchange rate depreciation and demand side equilibrium income is higher at any given price level. the increase in the income is equal to the rightward shift of the AD curve because the price level is assumed constant. the exchange rate depreciation has raised AD but not AS. the excess demand at the current level of prices trigers a price increase. this will reduce the real money supply and therefore the real exchange rate so exports fall. this will move the AE curve down in the keynsian cross and the IS curve left. on the AD curve this fall in income shows a movement left along the AD curve until it intersects the AS curve. there will be a movement along the AS curve as when there is a fall in prices, the real wage decreases resulting in demand for labour increasing