Week 7 - AD/AS Analysis model Flashcards
What is the use of the AD/AS model?
To explain the price level (inflation rate) and level of output (GDP) via a relationship between aggregate demand and aggregate supply
X and Y variables in AD/AS model
- Y - price level (represent inflation)
- X - output (represents economic growth)
What is aggregate supply?
Is the total supply of goods and services that firms plan on selling during a specific time frame - sim of every firms supply curve
Interpret a short-run aggregate supply curve (4)
- Upward sloping just like a firm’s individual supply curve
- Higher prices mean higher profits which incentivises businesses to expand output by hiring additional factors
- Prices of additional factors stay constant when moving along SRAS curve e.g wage and tech
- In the very SR we can assume that SRAS is perfectly elastic
What are Shifts in SRAS caused by?
changes in the conditions of supply such as cost of capital, cost of raw materials, commodity prices, cost of labour, government prices
Interpret a graph showing shifts in the SRAS
Increase in the cost of capital and cost of labour will shift the curve from SRAS1 to SRAS3 and a decrease will shift curve from SRAS1 to SRAS2
What determines the position of a LRAS curve? (2)
- State of technology
- Rate of invention
Characteristics of a Long run aggregate supply (LRAS) curve
- Shows the output firms wish to supply at each price level
- In the long run equilibrium output is independent of price because it is perfectly inelastic
3 types of aggregate supply curves
- Keynesian = perfectly elastic (inflexible prices)
- New classical model = perfectly inelastic (flexible prices
- Upward sloping = SRAS
Draw an aggregate demand curve
3 main reasons why aggregate demand curves slop down
- International competitiveness effect
- Real balance effect
- Interest rate effect
Why does the international competitiveness effect cause an aggregate demand curve to slope down?
Because when the economy’s price level rises the relative price of exports rises while the relative price of imports falls
Why does the real balance effect cause an aggregate demand curve to slope down?
Because when the economy’s price level rises the purchasing power of wealth such as financial assets falls
Why does the interest rate effect cause an aggregate demand curve to slope down?
Because when the economy’s price level rises the demand for money rises putting upward pressure on interest rates
Aggregate demand equation
Factos that impact domestic consumption demand (C) (5)
- Income
- Interest rates
- VAT
- Confidence
- Wealth
Factors that impact domestic investment demand (I) (4)
- Animal spirits - confidence in investment
- Interest rates - increased will lead to less investments
- Corporate tax rates - increase will lead to less investment
- Business subsidies - Increase will lead to greater investment
Factors that impact government spending (G) (3)
- Interest rates to finance borrowing
- Tax collection infrastructure - if it’s not good G will be lower
- Political preferences
Factors that impact export (X) and Import (M) demand (3)
- Exchange rates
- Domestic income
- Foreign income
Why might aggregate demand shift when price is constant? (3)
- Chnages in consumption habits
- Animal spirits and consumer confidence
- Expansionnary fiscal policy
- Expansionary monetary policy
(Increases will cause it to shift to the right whilst decreases will cause it to shift to the left)
What is the classical view on fiscal and monetary policy?
In the long-run chnages in fiscal and monetary policy have no impact on output
Impact of an increase in government spending (4)
- AD shifts from AD to AD
- If there was excess capacity the economy would move to position B, but there is no excess capacity available
- Price rises, economy overheats, interest rates thus reducing investment and consumer spending and we move back to position to C
- If that happens quickly this creates inflation
What happened during The Great Recession and credit crunch? (3)
- Credit dried up, investment and consumer demand fell - represented through shift from AD to AD2
- At there is a negative output gap which shows there is unemployment and falling prices but real wages have increased for those still in work
- If the govermenent & central bank does nothing then the excess supply of labour in the labour market will bring down the nominal wage - as a result SRAS shifts down and we end up at C where we are now at full employment
Stagflation of the 1970s (7)
- Oil shock shifts SRAS to SRAS2
- Animal spirits dented so AD shifts to AD2
- Stagflation causes the economy to go from A to B
- Energy inflation generates pay disputes and therefore workers’ pay is increased
- This causes SRAS to shift further to the left as cost-push inflation plagues the economy
- If the govermenent stimulates the demand (AD shifts to the right) more inflation results demand pull inflation
- To get to C costs need to fall - the economy needs to be reliant on oil which shifts SRAS2 to SRAS3
Keynesian economists thoughts on how quickly the economy adjusts (3)
- Argue that wages and prices are “sticky downwards” this means the adjustment is sluggish
- Active stabilisation policies are needed to get the economy back to equilibrium or economy will be stuck below full employment
- Labour Party would agree with this
Classical economics thoughts on how quickly the economy adjusts (3)
- Argue that the economy should be left alone to adjust by itself
- They would argue that government intervention has lots of unintended consequences and should pay off debt
- Conservative party would agree
How does a budgeted deficit/surplus occur? (2)
- Governments are constrained by how much they can increase government spending and/or decrease tax
- And if a government is spending more/less than what it earns in tax revenue it is running a budgeted deficit/surplus
How can a budgeted deficit be financed? And impact (3)
- Governments borrow from financial markets
- Sell gilts with varying levels of maturing
- This adds to the stock of public debt which the government pay interest on
Impact of national debt
Can put upward pressure on interest rates and burden future governments but historically the debt ratio is low
What does paying national debt depend on?
A country’s ability to control its own currency as a result money can be printed to pay off their debt but this can create hyperinflation
Interpret short run AD/AS model which analyses COVID-19
- Negative AD shock and negative AS shock
- Significant depress in real national income
Interpret medium run AD/AS model which analyses COVID-19 (2)
- As pandemic eases and vaccines are introduced the economy begins to recover
- Pent-up demand shifts AD back, SRAS starts to move back but perhaps more slowly and we start to see a rise in inflation
Interpret long run AD/AS model which analyses COVID-19
Growth in potential national income is important for living standards
Define hysteresis
Refers to an event in the economy that persists into the future, even after the factors that led to that event have been removed
Interpret a hysterisis growth path (3)
- No hysteresis (red line)
- Hysteresis as output losses permanent but predetermined rate of growth (blue line)
- Superhysteresis as output losses are permanent and longer term growth rate is lower
