Week 2: The aggregate supply-aggregate demand model And the Classic Keynesian debate

Question 1

The Classical versus Keynesian controversy is primarily a dispute over what?

Answer 1

A dispute over how an economy adjusts during a recession and finds it way back to full employement.
Classical economists believe a price adjustment mechanism would cure the economy (in event of unemployement, prices, wages and interest rates would all fall => this would increase consumption, production and investment and quickly return the economy back to its full employement equilibrium).
Keynesian economists believed that before the price adjustment mechanism could work, it is overpowered by a much more powerfull income adjustment mechanism (when an economy sinks into a recession, peoples income falls which reduces consumption, saving, investment and production => deeper recession rather than back to full employement)

Question 2

State Say’s Law

Answer 2

“Supply creates its own demand”
=> When people work they earn income.
=> Say’s law states that the total income must equal the value of the goods & services
=> If the workers spend this income, it must be enough to pay for all the goods & services they supply.
=> Therefore supply creates its own demand (i.e. agg. demand must equal agg. supply)

Question 3

What was Thomas Malthus’ critique of Say’s Law?

Answer 3

If workers don’t spend all their money but save it, then people would be out of work. (Answer by classical: Savings are invested in the economy => Agg Demand which is investment + Consumption would always equal agg supply)

Question 4

Use the circular flow diagram to illustrate Say’s Law.

Answer 4

HouseHolds Savings => Banks => Investment => Firms
Households => Consumption => Firms
Thus Agg Demand = consumption + investment

Question 5

Describe the quantity theory of money.

Answer 5

MV = PQ
Money supply
Velocity of money: amount of income generated each year by a dollar of money (aka how many times it changes owners)
general Price level => linked to an index (inflation measure)
Quantity of real output sold
=> Price level varies in response to changes in the quantity of money

Question 6

Explain the two major assumptions of the quantity theory of money.

Answer 6

Velocity of money and Quantity of output are fixed.

Question 7

Describe the Keynesian income adjustment mechanism.

Answer 7

Recession => people’s income falls
=> people spend & save less
=> business respond by investing & producing less
=> drives economy into deeper recession.

Question 8

Illustrate equilibrium in the aggregate supply-aggregate demand model.

Answer 8

Where AS and AD cross. At this point the price and output combination is compatible with the intention of both buyers and sellers. This equilibrium need not be at full potential output (can be more or less (recessionairy)). Either of the curves can shift and change equilibrium.

Question 9

Explain the three reasons why the .aggregate demand curve slopes downward.

Answer 9

• Real balance or wealth effect
• Interest rate effect
• Net export effect

Question 10

List at least five major reasons why the aggregate demand curve shifts.

Answer 10

• Change in consumer spending (consumer expectations, tax policy,…)
• Change in investment spending (lower interest rates, taxes, technology,…)
• Change in government spending (ethics,…)
• Change in net export spending (exchange rates,…)

Question 11

Why does the aggregate supply curve slope upward?

Answer 11

Because higher price levels create an incentive for businesses to produce more and sell additional output.

Question 12

List at least five reasons why the aggregate supply curve shifts.

Answer 12

• Change in input prices (domestic resource availability, prices of imorted resouces, market power,…)
• Change in tech and productivity (an increase in productivity means the economy can obtain more real output from its limited resources).
• Change in legal institutional environment.

Question 13

Draw and explain the three ranges of the economy

Answer 13

Keynesian range: ———-
Intermediate range: /
Classical range: |
|
P /
—— /
Q
*Keynesian range: increasing output will not lead to inflation. Economy either in severe recession or full blown depression. Large amounts of unused machinerey and equipment and unemployed workers available. Putting those resources back to work will have no effect on inflation. In this range prices are fixed. Fiscal policy can be used.
*Classical range: the only impact of expansionary fiscal policy is inflation. Q will not rise, only P will.
*Intermediate range: any expension of real output is accompanied by a rising price level.

Question 14

Draw and describe the Classical price adjustment mechanism.

Answer 14

Recover from recession because wages & prices fall so companies can hire more workers and produce more cheaply.

Question 15

What is the classical view?

Answer 15

Laissez-Faire economics => beste cure for recession is to leave the economy alone (little government involvment).

Question 16

What is the Keynesian view?

Answer 16

Heavy government intervention (fiscal policy)

Question 17

What are the two major pillars of classical economics

Answer 17

Says Law and the Quantity Theory of Money (PQ = MV)

Question 18

What do say’s law and the quantity theory of money determine

Answer 18

Says law determines real output.

Q theory of money determines price level.

Question 19

What is the “veil of money”

Answer 19

Real output is not influenced by money supply (increasing M will not increase Q in MV=PQ)

Question 20

What is the key difference in Price asumptions between classical and Keynesian economists

Answer 20

AS-AD framework has it roots in classical economics, it allows for price adjustment. However Keynesion model assumes prices are fixed

Question 21

What is the real balance or wealth effect?

Answer 21

as price levels fall (deflation), purchasing power increases, and consumers demand more goods & services. => e.g. A lower price level (deflation) increases the real value or purchasing power of saving accounts.

Question 22

What is the interest rate effect?

Answer 22

As price level falls, so do interest rates. => falling interest rates increase investment spending by businesses and certain kinds of consumer spending on items such as automobiles and houses.

Question 23

What is the net export effect?

Answer 23

As the domestic price level falls, the relative price of foreign goods increase. This reduces demand for the now more expensive imports, increases exports and thereby increases agg Quantity demanded.

Question 24

What is price level in AD-AS model?

Answer 24

The general price level is a hypothetical measure of overall prices for some set of goods and services, in a given region during a given interval, normalized relative to some base set. Typically, a price level is approximated with a price index.