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Question 1

Production potential (Yp) &

Answer 1

the production capacity of the economy, using all factors of production

In SR, Y (actual GDP) fluctuates around Yp

Question 2

Output gap

Answer 2

Output gap = Y – Yp

Y < Yp : Underemployment gap; Unemployment rate > Natural unemployment

Y = Yp : Full employment gap; Unemployment rate = Natural unemployment

Y > Yp : Overemployment gap; Unemployment rate < Natural unemployment

Question 3

Real balance effect

Answer 3

change in consumption caused by a change in the real value of financial assets that have fixed dollar values

↑Prices; ↑ Demand for money; ↑SR interest rate; Investment less profitable in SR

Question 4

Interest rate effect:

Answer 4

The effect of an increase or decrease in aggregate demand in an economy due to changes in interest rates set by the central bank. Interest rates have an inverse relationship with aggregate demand.

↑ Price level ↑ interest rate ↓Business investment & ↓C

Question 5

Firms’ production in the SR

Answer 5

Firms will produce more or less in the SR depending on the profitability of producing
If Prices ↑; firms can sell at higher Prices without paying wages more so ↑production
If Prices ↓; firms must sell at higher prices without decreasing the wages so ↓production

Changes in production costs impact only SRAS and not production potential, only SRAS move

Question 6

↓ In the economy’s production capacity:

Answer 6

• If natural unemployment ↑
• Number of available workers ↓ due to massive retirements that are not fully filled by new entrants in labour force

Question 7

Factors who move LRAS and SRAS in the same direction and proportion

Answer 7

• Capital
• Number of available workers
• Human capital
• Natural resources

Question 8

Factors who shift SRAS

Answer 8

• Production cost↑: SRAS to the left
• Production cost↓: SRAS to the right

Question 9

AD shift factors

Answer 9

1. G (+):
   ↑G; AD↑ (to the right)
2. C:
   a. Disposable income (+):
   ↑Disposable income ↑AD (to the right)
   b. Interest rate (-):
   ↑Interest rate ↑S, so ↓C ↓AD (to the left)
   c. Wealth effect (+):
   ↓S (need to save) so C↑ AD↑ (to the right)
   d. Expectations (+):
   ↓C ↑AD (to the right)
3. I:
   a. Interest rate (-):
   ↑Interest rate ↓I ↓AD (to the left)
   b. Expectations (+):
   ↑Optimism, ↑I ↑AD (to the right)
   c. Oil price (+):
   For net oil exporters whose oil sectors is a large share of GDP: oil price changes will affect SRAS & AD through an ↑I

Question 10

Effect of moving SRAS to the right (↑)

Answer 10

• ↓ inflation
• ↑ growth (↓unemployment)

Question 11

Effect of moving AD to the left (↓)

Answer 11

• ↓ growth (↑ unemployment)
• ↓ inflation

Question 12

In overheated environment (Y > Yp)

Answer 12

wages and other production costs will ↑, production will become less profitable and SRAS will slowly (↓)shift to the left
- The inverse for Y < Yp
Takes longer for the economy to return to potential when Y < Yp than when Y > Yp