Understanding the curves Flashcards
Why is AD downward sloping
Real Balance effect
- as the price level falls, this increases the purchasing power of consumers, meaning that there will be an expansion in real output.
- Conversely, as the price level increases, this erodes household wealth, causing a negative wealth effect, meaning that the household is likely to spend less, representing a contraction in real output
Trade effect
- a higher price level makes UK exports less price competitive relative to the rest of the world
- therefore, demand for our exports would decrease.
- the price of our exports will therefore decrease
- decreased value of net exports
- decreased real output
Interest rate effect
- a higher price level means that firms and households need to spend more to buy the same amount of goods and services as they did before
- demand for loanable funds will increase, or in any case interest rates will rise to bring down inflation
- more expensive to borrow and more rewarding to save
- investment decreases, consumption decreases
- contraction in RO
Why is the SRAS curve upward sloping?
Increased profitability
- in the short run, we assume that the factors of production remain constant, therefore the prices of the factor inputs remain the same
- therefore, at a higher price level, the firm will be making more profits, incentivsing firms to increase output
Explain the neoclassical economist’s description of the LRAS curve
Neoclassical Economists
- in the long run, negative or positive output gap will not exist because the market will self adjust
- no need for government intervention
- their LRAS curve is completely inelastic
- in a negative output gap, the equilibrium level of output is below YFE.
- therefore, there is a decreased derived demand for labour, as not all the factors of production are being fully utilised.
- there is spare capacity in the economy
- firms will be able to charge workers lower wages, since there is more competition for the same job, decreasing firms’ costs of production
- this will result in a rightwards shift of the LRAS curve, as at a given price, firms will be more willing and able to supply more
- therefore, the new equilibrium will be at YFE, where the SRAS intersects the LRAS curve
- in a positive output gap, the economy is overheating
- all factors of production are being used, and they are being used at an unsustainable level
-high consumption, probably high inflation as well - workers might be forced to work overtime, therefore they will demand pay rises
- therefore, the CoP for firms will rise, causing a leftwards shift in the LRAS curve
Explain the Keynesian economist’s description of the LRAS curve
- govt intervention is needed in order to bring the economy back to YFE
- Keynesian economists argue that wages won’t fall, because they are ‘sticky downwards’ - workers will in reality be unlikely to accept pay cuts.
- TU’s and strikes can force wages to stay the same
- minimum wage also restricts wage decreases, if on minimum wage
- at first, the LRAS curve has a flat gradient
- this is during the period of mass unemployment
- scarcity doesn’t apply here because there is plenty of excess supply of workers
- firms can increase production without having to pay more (than they normally pay) to hire extra workers
- eventually, scarcity of workers kicks in
- this gives workers more leverage - firms have to compensate workers more for each additional worker they hire
- workers are scarce enough that an increase in demand for labour will push up wages
- pushes up CoP
- pushes up price level
- at full employment, any increase in demand for labour won’t add to real output, but will only lead to inflation, as workers will demand higher wages
Explain the SRPC
- Keynesian economist Alban Philips plotted data which became known as the Short run Phillips Curve
- it shows the trade-off between inflation and unemployment
- according to the model, there is an inverse relationship between unemployment and inflation. A decrease in the unemployment level will lead to an increase in inflation
- this can be explained using AS/AD analysis
- demand led economic growth causes an increase in the general price level, and an increase in real output
- due to this increase in real output, firms will higher more workers to satisfy its increased demand, meaning that there is increased derived demand for labour
- higher wages, lower unemployment
- in particular, as unemployment falls, there is greater scarcity of workers, giving them greater bargaining power of their wages
- this increases the cost of production of firms, leading to inflation
Explain the LRPC
- monetarists deviate from the SRPC model
- Friedman and other monetarist economists came up with the model for the Expectations Augmented Phillips Curve
- initial equilibrium is the intersection between LRAS, SRAS and AD
- if the authorities implement an expansionary demand side policy, for example by reducing interest rates to make credit cheaper, then there will be a rightward shift in AD, causing an increase in the price level, and adding to real output
- the voluntarily unemployed become attracted to work at higher nominal wage rates being offered by firms due to the shortage in supply of labour and the need to satisfy greater demand
- however, as they adapt their expectations, they realise that these expansionary fiscal policies create an upwards pressure on price, meaning that their real wages haven’t actually increased
- therefore they will seek even higher wages, or leave the labour market
- increased CoP for firms
- leftward shift in supply back to LRAS equilibrium, but with higher inflation
- shows how there is a natural rate of unemployment
why is the supply curve upward sloping
profit motive - as prices increase, firms are incentivised to supply a greater quantity of the good so that they can increase their total revenue, and make more profit
covering variable costs - in order to expand production in the short run, higher prices will be needed to cover rising variable costs
diminishing marginal returns - as production expands, it could be argued that firms suffer from diminishing marginal returns - each additional worker contributes less and less to total product, and so marginal costs increase, causing the price to rise as output increases
why is the demand curve downward sloping
- substitution effect - as the price of a good rises, the quantity demanded falls because people will switch to cheaper alternatives. they will substitute the expensive good for a cheaper good, so as the price rises, the quantity demanded by consumers falls
- diminishing marginal utility - as more of the product is consumed, the additional benefit to the consumer falls, meaning that consumers will only be prepared to pay less for a higher quantity. Consumers have less need or desire for a greater quantity of the good, as once they have consumed one unit, they are often not in need of a second unit.
- income effect - as the price of goods falls, people’s real incomes, meaning the purchasing power of consumers, will rise, meaning that consumers will increase their demand for the good
