Topic 4 - Aggregate Demand / Aggregate Supply

Question 1

4.01 - What does aggregate demand represent?

Answer 1

The amount of goods and services that consumers, businesses, government and foreign buyers are willing and able to buy at various price levels

Question 2

4.02 - Which way does the AD curve slope and what are the three causes of this?

Answer 2

Downwards to the right, because of:

• The interest rate effect
• The real balances effect
• Foreign Purchases effect

Question 3

4.03 - Explain what the interest rate effect is and why it affects the AD curve?

Answer 3

As the price level rises so do nominal interest rates, rising interest rates in turn cause reductions in certain kinds of consumption and most importantly investment spending. So AD is less as the price level rises and more when it falls.

Question 4

4.04 - Explain what the real-balances effect is and how it affects the AD curve?

Answer 4

At a higher price level the real value or purchasing power of the accumulated financial assets held by the public falls; the fall in real wealth of the public leads to a reduction in consumption expenditures (also referred to as the wealth effect). So less AD as the price level rises.

Question 5

4.05 - Explain what the foreign purchases effect is and how it affects the AD curve?

Answer 5

A rise in our domestic price level increases our imports and reduces our exports, thereby reducing net exports, so there is less AD as the price level rises.

Question 6

4.06 - What does the effect of lower prices levels have on the Aggregate Expenditures model?

Answer 6

• reduces interest rates and increases investment
• increases real value of wealth boosting consumption
• reduces imports and increases exports, raising net export expenditures.

Question 7

4.07 - What are the determinants of aggregate demand?

Answer 7

1) changes in consumer spending
2) changes in investment
3) changes in government spending
4) changes in net export spending
(C, I, G, NX)

Question 8

4.08 - What are the components of consumer spending that can shift the aggregate demand curve?

Answer 8

• Consumer wealth
• Consumer expectations of future
• Consumer’s level of debt
• Rate of taxes

Question 9

4.09 - What are the components of investment spending that can shift the aggregate demand curve?

Answer 9

• Interest rates
• profit expectations on investment projects
• Business taxes
• Technology
• Degree of excess capacity

Question 10

4.10 - What are the two key components of net export spending that can shift the aggregate demand curve?

Answer 10

• Growth in foreign GDP (if their incomes rise they are likely to demand higher amounts of Aust product)
• Exchange rates

Question 11

4.11 - What is the calculation for the shift in the AD curve?

Answer 11

Shift in the AD Curve = initial change in spending x the multiplier

Question 12

4.12 - What does the aggregate supply curve indicate?

Answer 12

It indicates the level of real domestic output that will be produced at each possible price level. There is a direct or positive relationship between the price level and real GDP. So higher price levels create an incentive to produce and sell additional products. Lower prices are associated with a reduction in output.

Question 13

4.13 - What is the short run?

Answer 13

It is a period in which input prices, particularly nominal wages, remain fixed while other prices change.

Question 14

4.14 - Why are input prices fixed in the short run?

Answer 14

• Workers not being aware of higher or lower prices; and

* The existence of fixed wage contracts.

Question 15

4.15 - Describe the shape of the short-run aggregate supply curve and why?

Answer 15

It is upward sloping because an increase the the price level increases profits and real output, where as a decrease lowers profits and therefore output decreases.

Question 16

4.16 - What is the long run?

Answer 16

It is a period in which input prices (wages etc) are fully responsible to changes in the price level. Workers are freed from existing wage contracts and can negotiate new nominal wages and salaries.

Question 17

4.17 - Describe the Long-run aggregate supply curve and where it is located?

Answer 17

The ASLR is vertical at the level where potential output is consistent with the economy’s natural rate of unemployment.

Question 18

4.18 - What are the determinants of aggregate supply?

Answer 18

1) Change in input prices
2) Productivity changes
3) Legal and institutional environment changes

Question 19

4.19 - What are the components of a ‘change in input price’ that could affect the aggregate supply?

Answer 19

• Domestic resource availability (land, labour, capital and entrepreneurial ability)
• Prices of imported resources
• Market power shifts

Question 20

4.20 - How does ‘productivity’ changes affect the aggregate supply?

Answer 20

An increase in productivity means that more real domestic product can be obtained from the same amount of resources or inputs.

Question 21

4.21 - How can we determine how an increase in productivity affects the Aggregate Supply curves?

Answer 21

Through the formula: per-unit production cost = total input cost/units of output.

Question 22

4.22 - What are the two main types of legal and institutional environment changes that could cause a change to the aggregate supply curve?

Answer 22

They are

• changes in taxes and subsidies, and
• changes in the extent of regulation.

Question 23

4.23 - Where does equilibrium occur on a aggregate supply / demand model?

Answer 23

The intersection of AS and AD determines equilibrium real GDP and the price level. At all other points there will be pressure on real GDP and/ or unit prices

Question 24

4.24 - What is the ratchet effect?

Answer 24

The ratchet effect is the result of both products and resources to be individually ‘sticky’ or inflexible in a downward direction, leading to a loss in downward flexibility of the general level of prices.

Question 25

4.25 - What are the causes of the ratchet effect (downward price inflexibility)?

Answer 25

• Wage inflexibility - represent about 70% of a firms cost and are not easy to decrease
• employer’s interests - reduction of workforce may not be wanted due to (1) morale and (2) investment made in these workers
• Monopoly power - ability to resist price cuts
• menu costs - difficulty of implementing price changes

Question 26

4.26 - What is cost-push inflation?

Answer 26

It is inflation associated purely with shifts in the aggregate supply due to cost factors, along a stable aggregate demand curve.

Question 27

4.27 - What do adverse shifts in aggregate supply result in?

Answer 27

Stagflation - which is the simultaneous experience of both high and increasing unemployment and inflation

Question 28

4.28 - In a range 1 level of full employment output, what effect does the multiplier have?

Answer 28

Full multiplier effect is felt in the horizontal range of the aggregate supply curve, because price will not change much but GDP will.

Question 29

4.29 - In a range 2 level of full employment output, what effect does the multiplier have?

Answer 29

A reduced multiplier effect is felt in the intermediate range of the aggregate supply curve. Price starts to increase because of inflation as the economy is moving towards full employment

Question 30

4.30 - In a range 3 level of full employment output, what effect does the multiplier have?

Answer 30

There is no multiplier effect in the vertical range of the aggregate supply curve. This is because GDP has no where to move, as you are at full employment. In this case inflation will rise quickly resulting in higher prices.

Question 31

4.31 - What is the foreign purchases effect?

Answer 31

It is the effect where a rise in our domestic price level increases our imports and reduces our exports, thereby reducing net exports.

Question 32

4.32 - What two items can reduce the effectiveness of expansionary fiscal policy?

Answer 32

• Inflation - this is caused by interest rate increases, which attract foreign capital
• Crowding out - with foreign capital, the dollar appreciates, and net exports will fall reducing the effectiveness of the policy

Question 33

4.33 - What are two international conditions that can affect the effectiveness of fiscal policy?

Answer 33

1) Shocks from abroad

2) Net export effect

Question 34

4.34 - What is the net export effect?

Answer 34

The impact of interest rate induced change in the exchange rate and thus net exports following changes in fiscal policy.

Question 35

4.35 - What is the effect of expansionary fiscal policy on the Australian dollar?

Answer 35

It results in higher interest rates resulting in increased demand for the Australian dollar resulting in a decline in net exports.

Question 36

4.36 - How does fiscal policy affect aggregate supply?

Answer 36

Tax changes in the form of incentives to business and individual can lead to a rightward shift in AS, providing a further stimulus to the economy in terms of lower prices and higher GDP.

Question 37

4.37 - Explain the difference in opinion between supply-side economists and Keynesian analysts?

Answer 37

Supply-side economists strongly favour reduction in taxes to increase demand, where as Keynesian analysts believe that tax cuts reduce tax revenues and increase budget deficits.