Week 7 Lecture 2

Question 1

What conditions are satisfied when the economy is in long-run equilibrium?

Answer 1

• Output = Natural output
• Expected price level = Actual price level
• The AD, SRAS and LRAS curves all intersect at the same point

Question 2

Explain the economic fluctuations that occur when there is a contraction in aggregate demand (AD shifts left)

Answer 2

• When AD shifts left this leads to a demand driven contraction where output falls, unemployment increases and the price level falls
• With time however, the SRAS curve shifts right and output reverts to its natural rate as the price level adjusts downwards

Question 3

Draw a diagram to show the economic fluctuations that occur when there is a contraction in AD

Answer 3

See slide 6 of Week 7 Lecture 2

Question 4

When the price level drops on a AD contraction diagram, what does this show us?

Answer 4

The drop in price from p1 to p2 shows us that actual price level is now less than the expected price level

Question 5

Explain the economic fluctuations that occur when there is a contraction in aggregate supply (AS shifts left)

Answer 5

• When AS shifts left this leads to an aggregate supply driven contraction
• Output falls, the price level increases and stagflation occurs
• With time however SRAS shifts back to the right and output reverts to its natural rate as the price level falls

Question 6

If the AD or AS curve shifts to the right what type of economic fluctuation occurs?

Answer 6

We get aggregate demand driven expansion or an aggregate supply driven expansion (both booms)

Question 7

When SRAS shifts left, how may policymakers react to counter the drop in output?

Answer 7

• The may elect to shift the AD curve right so that output returns more quickly to its natural rate
• The cost of this is higher inflation will occur

Question 8

Draw a diagram to show how policymakers elect to shift AD right to combat AS shifting left

Answer 8

See slide 14 of Week 7 Lecture 2

Question 9

What are the two possible ways in which policymakers can shift the AD curve?

Answer 9

• Monetary policy (Changes in the money supply and/or interest rates)
• Fiscal policy (changes in government spending)

Question 10

Draw a diagram to show how expansive monetary policy increases AD through an increase in the money supply

Answer 10

See slide 16 of Week 7 Lecture 2

Question 11

Explain how changes in the money supply shifts the AD curve

Answer 11

• An increase in the money supply leads to lower interest rates which is expansionary (shifts AD to the right for any given price level)
• A decrease in the money supply leads to higher interest rates which is contractive (shifts AD to the left for any given price level)

Question 12

What effect does fiscal policy have on the AD curve?

Answer 12

Fiscal policy directly shifts the AD curve to the right if the fiscal policy is expansionary and to the left if the fiscal policy is contractionary

Question 13

What does whether a £1 increase in net government spending leads to AD rising by more or less than £1 depend on?

Answer 13

It depends on the relative size of these two opposing effects:
- Multiplier effect (Amplifies the effect on AD of an increase in net expenditure)
- Crowding out effect (Diminishes the effect on AD of an increase in net expenditure)

Question 14

How does the effect does the multiplier effect have on a shift right in AD due to an injection?

Answer 14

The multiplier effect causes a further shift right in AD after the original shift due to the injection