Aggregate Demand, SRAS, LRAS, Long-Run Self Adjustment

Question 1

What is Aggregate Demand? What is the relationship between price level and Real GDP

Answer 1

Aggregate demand refers to all the goods and services that consumers, firms, and governments are willing and able to purchase at various price levels. GDP is shown for the x-axis

Relationship between the price level and Real GDP output demanded is inverse. As the price level rises, consumers, firms, and government are less willing or less able to purchase the same quantity of Real GDP output and, therefore, end up buying less. As the price level falls, consumers, firms, government, and foreign consumers are more willing or more able to purchase the same quantity of Real GDP output and therefore buy more.

Question 2

Why is Aggregate Demand downward sloping? Draw it.

Answer 2

Real Wealth Effect: Higher prices reduce the purchasing power of money and assets. Lower prices increase the purchasing power of money and assets. As purchasing power changes, the consumption of goods and services will change as well.
Interest Rate Effect: Prices and interest rates mirror each other. As interest rates rise, firms take out fewer loans and invest less in themselves. As interest rates fall, firms take out more loans and invest in themselves more.
Foreign Trade Effect: As prices rise domestically, exported goods and services become more expensive, and foreign consumers buy less. As prices fall domestically, exported goods and services become cheaper, and foreign consumers buy more.
When prices increase, the aggregate real GDP output demanded decrease
Graph shows aggregate demand. You can see that, as price rises, real GDP decreases, and as price falls, real GDP increases.
Just like with demand for an individual good or service, a change in price level moves us along the aggregate demand curve

Question 3

What are the shifters of Aggregate Demand? What happens if there is a change in price level?

Answer 3

Factors include all the components of GDP: consumer spending, investment spending, government spending, and net exports. Any changes due to price level have no effect on the AD curve.

Question 4

What are the shifters of Consumer spending?

Answer 4

The aggregate spending of all consumers on all domestic goods and services

Level of household income: At higher incomes, consumption rises, at lower incomes consumption decreases

Wealth: If wealth rises, households feel richer and consumers more. If wealth declines, households feel poorer and consumer less

Real Interest rates: If interest rates are higher, households will prefer to save more and consume less. At lower interest rates, consumption is higher, savings is less

Household Debt: At high debt levels, households must allocate more income to paying off debts, therefore consumption falls

Household confidence: If households are confident about future incomes or employment opportunities, they are likely to spend more now, so consumption will increase

Question 5

What are the shifters of Investment spending?

Answer 5

Investment Spending: The aggregate spending of all firms on themselves in effort to achieve future productivity and profitability

Real Interest rates: At lower interest rates, firms will borrow more money and buy new capital equipment. If interest rates are higher, firms will invest less.

Expectations of firms (confidence): Firms are confident about future business opportunities, higher investment now. If expectations are poor, firms will invest less now.

Question 6

What are the shifters of government spending?

Answer 6

Government Spending: The aggregate spending at all levels of government on all domestic goods and services
Fiscal Policy: Level of taxation and government spending. Lower taxes increase AD.

Government debt: More debt may mean more government spending in the short-run, but debt must be paid off in the long run, so taxes have to be raised and government spending must fall if there is too much government debt

Question 7

What are the shifters of Net exports?

Answer 7

Net Exports(Exports- Imports): The difference in aggregate spending by foreign consumers on exported goods and services and domestic spending on imported goods and services from other countries

Incomes of foreign consumers: If foreign incomes rise, demand for exports increase and net exports rise
Domestic incomes rise: As domestic households get richer they will demand more imports, so net export spending may fall

Exchange rates: If the currency gets stronger, exports will be more expensive to foreign consumers, so net exports will fall. If the currency gets weaker foreigners will demand more of the country’s goods and net exports will rise.

Question 8

For each scenario below determine whether the scenario would increase or decrease aggregate demand and what factor is causing this to happen

South Korea consumer confidence soars

The British Government votes to shrink the size of its military

Due to severe drought, China’s inflation rate climbs 4%

As the economy grows and profits increase, Italian firms begin to build more factories

The US Congress removes a tariff on imported goods, making them less expensive

Answer 8

South Korea consumer confidence soars
Increase in aggregate demand due to an increase in consumer spending

The British Government votes to shrink the size of its military
A decrease in aggregate demand because there is a decrease in government spending since they are not spending as much money on their military

Due to severe drought, China’s inflation rate climbs 4%
This is a movement along the curve. The amount of real GDP will decrease because there is an increase in the price level (inflation)

As the economy grows and profits increase, Italian firms begin to build more factories
This would be an increase in aggregate demand because it is an increase in investment spending by firms in italy

The US Congress removes a tariff on imported goods, making them less expensive
This would be a decrease in aggregate demand because as imported goods become less expensive we will see the amount of these goods purchased increase. Since the formula for net exports is exports - imports, when imports increase that number actually decreases which causes a decrease in aggregate demand.

Question 9

What is SRAS? What is the relationship between price level and real GDP? Draw it

Answer 9

Aggregate supply is the relationship between price level of all stuff made within a country’s borders and the amount of stuff made we also have something called Short Run AS and Long Run AS

Short Run Aggregate Supply represents all the goods and services that firms are willing and able to produce at various price levels.

Law Surrounding SRAS is very similar to the law of supply of individual goods and services. The relationship that exists between the price level and real GDP output supplied is positive. This means as the price level rises, firms are willing or able to produce greater quantities of real GDP output. As the price level falls, firms are only willing or able to produce a lesser quantity of real GDP output

When prices decrease, the aggregate real GDP output supplied decreases
The short-run aggregate supply is upward sloping because wages and resource prices are not flexible (sticky) in the short run.
Just like with supply for an individual good or service, a change in price level moves along the aggregate supply curve

Question 10

What are the shifters of SRAS?

Answer 10

Factors include resource prices and availability, actions of the government and the productivity and technology. (RAP Acronym)

R: Resource prices/ Availability: When the cost associated with securing resources as well as the availability of resources increases or decreases then SRAS will increase or decrease.
EX. If wages increases 2% across the aUnited states then the supply of goods and services will decrease
A: Actions of the government: This is the use of taxes, subsidies, and regulation on firms in the domestic industry
EX. If OSHA decides to implement a new limitation on pollution for factories than we’ll see aggregate supply decrease.
P: Productivity/Technology: This involves when there is a change in the output produced per unit of input as well as the use of automation in the production process
EX. When a worker productivity decreases, we will see a decrease in aggregate supply

Question 11

What does SRAS show relationship of? How does this relate to unemployment?

Answer 11

SRAS curve shows a relationship with an increase in price level and an increase in output. Anything Associated with price will be a shift along the SRAS curve, while any other RAP factors affecting SRAS will shift it right or left. In order for SRAS to show the correct relationship, employment should also rise. If employment is held constant while prices rise, unemployment will decrease. So, we know SRAS will show a short run trade off between inflation and unemployment

Question 12

For each scenario below determine whether the scenario would increase or decrease aggregate supply or decrease in aggregate supply

The Canadian Prime Minister places new regulations on carbon emissions

An increase in consumer income causes the GDP deflator to rise to 110

Automation in the workplace doubles productivity for all firms

A war with Great Britain Destroys Spanish Coal refineries

Answer 12

The Canadian Prime Minister places new regulations on carbon emissions

This would cause a decrease in aggregate supply because it is a regulation of the government that increases the cost of production for suppliers which will decrease aggregate supply

An increase in consumer income causes the GDP deflator to rise to 110

GDP deflator is an indication of inflation rate, since this has risen,, inflation has increased which is an indicator that price levels have increased. When price levels increase, there is a decrease in the amount of real GDP that is supplied, this is a movement along the aggregate supply curve instead of a shift of the curve

Automation in the workplace doubles productivity for all firms

This will cause an increase in aggregate supply because new technology has led to firms being more productive at all price levels

A war with Great Britain Destroys Spanish Coal refineries

This will cause a decrease in aggregate supply. This falls in the factors of resource availability. Since coal refineries have been destroyed less coal available to use in the production process. With less coal available, we will see a decrease in aggregate supply.

Question 13

What is LRAS? What is the relationship between price level and real GDP? Draw the graph explain.

Answer 13

Long-run Aggregate supply is defined as the number of goods and services that an economy is capable of producing with the full employment of resources

The relationship between the price level and real GDP output supplied in the long run is constant. As the price level rises or falls, firms will not alter the quantity of real GDP output they produce
In the long run wages and resources prices are flexible (sticky)When price level increases, wages will increase by the same amount.

The long-run aggregate supply curve (LRAS) is vertical at full-employment. YF represents the quantity of output the society can produce when they are at full employment and at the natural rate of unemployment. The LRAS curve shifting to the right can correspond with the production possibility curve (PPC) because both of them represent production capacity. It can also refer to economic growth. Whenever LRAS shifting to the right is mentioned, you can automatically pair that with the PPC expanding outward and economic growth.

Question 14

Which factors cause change to LRAS?

Answer 14

LRAS shifts anytime a situation would cause the production possibilities curve to shift. The difference between a change in the SRAS and LRAS is that we are looking at changing the potential output of an economy with LRAS and not the actual output at the time, as we do with SRAS. The shifting of the LRAS happens when there is a change in:

The number of resources (factors of production such as larger labor force, more capital, more natural resources)

The quality of resources (factors of production such as better technology that increases productivity of labor and capital)
Policy (incentives or policies that works to increase employment)

Any of these factors can cause an increase in the potential output of an economy, which will shift the LRAS to the right, or a decrease in the potential output of an economy, which will shift the LRAS to the left.

Question 15

What are the shifters of LRAS?

Answer 15

Shifters of LRAS

A change in the number of resources that could impact the LRAS includes a change:

The size of the work force
The number of land resources available
Capital Stock

Examples in this category that could increase the LRAS include:

A larger workforce, an increase in land resources
An increase in capital stock
A decrease in the size of the workforce or population
Depletion of land resources
Destruction of capital

A change in the quality of resources that could impact LRAS:

A better educated and more highly skilled workforce
An improvement in the quality of land resources
An improvement in the capital

Question 16

Explain the two types of equilibrium in an aggregate economy? Draw it out.

Answer 16

Aggregate equilibrium is very similar to equilibrium with demand and supply for an individual good or service. There are two types of equilibrium when we are referring to the aggregate economy. Short-run aggregate equilibrium occurs when the quantity of aggregate demanded is equal to the quantity of aggregate supply. This is displayed on a graph by the intersection of SRAS and aggregate demand (AD). If you took micro, this’ll look familiar
Long-run equilibrium occurs when the current output is also equal to potential output. This is demonstrated by the intersection of SRAS, AD, and LRAS. This is also referred to as the full-employment level of real output.

Question 17

Explain the equilibrium gaps in terms of price level, and the different gaps. Draw it out.

Answer 17

If the price level increases above equilibrium, then you have a surplus in GDP. This means that your aggregate supply is greater than your aggregate demand. If the price level decreases below equilibrium, then you have a shortage in GDP. This means that your aggregate demand is greater than your aggregate supply
Short-run equilibrium output can be at the full-employment of output, above it or below it. If the short-run equilibrium is below it, then it creates what we cause a recessionary gap (negative output gap). If the short-run equilibrium is above it, it creates what we cause an inflationary gap (positive output gap).
Remember that when AD and SRAS intersect but it’s to the left of LRAS, it’s a recessionary gap because the intersection is “falling behind”. Similarly, when the intersection is to the right of LRAS, it’s an inflationary gap because the intersection is “moving ahead”.

Question 18

Explain Inflationary Gap

Answer 18

Inflationary gap is a condition where an economy is producing a short-run Real GDP output that is beyond its potential Real GDP output at full employment. At first, it might seem like a good thing that we have a lot of production going on right? But the key to economics is this: equilibrium! This type of situation can lead to an overheating economy, which drives prices up and eventually decreases consumer purchasing power and consumption, which will cause a contraction of the economy. In an inflationary gap, the economy is producing more than the potential Real GDP and their unemployment levels are lower than what is considered full employment (4-6%).

Question 19

Explain Recessionary Gap

Answer 19

Recessionary gap is a condition where an economy is producing a short-run Real GDP output that is less than its potential Real GDP at full employment. This type of situation leads to the economy producing below its potential, and unemployment increases, and income levels, consumption, and the standard of living decreases. In a recessionary gap, the economy is producing less than the potential Real GDP, and their unemployment levels are higher than what is considered full employment (4-6%).

Question 20

Changes in the AD-AS Model: What is a shocks in the AD and AS model?

Answer 20

Positive supply shock, negative supply shock

Question 21

Explain negative supply shock?

Answer 21

In addition to these determinants of aggregate demand and aggregate supply, changes in the AD-AS Model can also occur from both negative supply shocks and positive supply shocks. A negative supply shock is an unexpected decrease in the availability of a key resource that temporarily decreases productivity. A negative supply shock will raise production costs and reduce the quantity that producers are willing to supply at any price level. This leads to a leftward shift of the short-run aggregate supply curve.

Question 22

Explain positive supply shock?

Answer 22

A positive supply shock is an unexpected increase in the availability of a key resource that temporarily increases productivity. A positive supply shock will lower production costs and increase the quantity that producers are willing to supply at any price level.

Question 23

What happens to Real GDP, Unemployment, and price level and AD increases and decreases, SRAS increases and decreases?

Answer 23

AD up, Real GDP up, unemployment down, price level up

Ad down, Real GDP down, unemployment up, price level down

SRAS up, Real GDP up, unemployment down price level down

SRAS down, Real GDP down, unemployment up, Price Level up

Question 24

Describe the Short Run Changes in AD- AS model. Draw it.

Scenario 1: Consumer Income Decreases as Taxes Increase

Answer 24

When taxes are increased, that allows for less consumer disposable income. This, in turn, will lead to consumers spending less money. The component of aggregate demand known as consumer spending will decrease, which leads to a decrease (leftward shift) of the aggregate demand curve. This causes a decrease in price level and a decrease in GDP.

Question 25

Scenario 2: The British Government increases tariffs on imported inputs

Answer 25

Tariffs are taxes on goods. In this particular scenario, the British government is placing tariffs on inputs (resources) that are coming into the country. That will raise the cost of these inputs (resources), making production costs greater for individual companies. With greater production costs, firms will produce less of their goods. This is shown by a decrease in the SRAS (shift to the left). This causes an increase in price level and a decrease in GDP.

Question 26

Scenario 3: Spanish exports become cheaper on the world market

Answer 26

When the costs of exports become cheaper, other countries will be more willing to purchase goods from Spain. As they purchase more goods, this will affect the determinant known as net exports. When exports increase, net exports also increase. This causes an increase in aggregate demand (shift to the right) which causes an increase in price level and an increase in GDP.

Question 27

Scenario 4: Corporate Taxes are reduced

Answer 27

When corporate taxes are decreased, it lowers production costs for firms (businesses). With the lowering of production costs, the firms are able to increase their overall output. This is shown by shifting the SRAS to the right. This increase in the SRAS will cause the overall price level to drop and the real GDP to increase.

Question 28

What is Long-Run self Adjustment?

Answer 28

When situations happen in the short-run that shift either aggregate demand or aggregate supply, there has to be an adjustment back to the long-run. In the absence of government intervention, the economy self corrects itself in a variety of different ways. In a sense, long term adjustment is basically price adjustment. It’s about bringing things back to long-run equilibrium.

Question 29

Describe how an increase in LRAS causes greater output, and LRAS shifting left with shocks?

Answer 29

Shocks are never anticipated. Shocks move the AD curve, but one thing to keep in mind is that it only matters in the short run. If there is a shift in the AD curve, yes output and unemployment will change in the short run, but it won’t in the long run. That’s why in the long-run, everything will be adjusted back to equilibrium. But what if the shock is permanent?

If the shock is permanent and makes the entire economy less productive, the entire capacity of the economy will decrease. In this case, LRAS will shift to the left (think of this as a shrinking of the production possibilities frontier). Because production costs are now higher, SRAS will also decrease and output will be permanently lower, leading to a permanently higher price level.

Therefore, only an increase in LRAS will lead to a great output of the economy in the long-run! Remember, an economy’s ability to self-adjust does not depend on AD or SRAS. It actually depends on its resources! This is why moving LRAS to the right (expanding production possibilities frontier) will improve the economy and its ability to produce at full employment.

Question 30

Explain the LR self adjustment of a recessionary gap. Draw the graph.

Answer 30

You’ll remember from earlier that during a recessionary gap, the equilibrium (B) is on the left side of LRAS. SRAS1 and AD are intersecting at B instead of It describes a situation where the economy is producing within its production possibilities frontier. The gap between Q2 and Yf describes the shortfall of real GDP and from full employment. As you can see, LRAS does not intersect at B, but in order to have a long-term equilibrium, we need LRAS to intersect as well.

This is because recession causes the economy to not take advantage of all of its resources like labor. Because labor is not used at full potential, workers will ask for businesses to lower their wages in an attempt to increase employment. As a result, firms will increase output, shifting SRAS to the right. Since the worker’s wages are decreasing, there is a decrease in production costs for firms. This will cause the economy to self-correct by moving from SRAS1 back to SRAS.

Question 31

Explain the SR adjustment of an inflationary Gap. Draw the graph.

Answer 31

Inflation happens when the economy is over-producing. The equilibrium (B) is on the right side of LRAS and real GDP is above the full-employment potential. But because LRAS doesn’t intersect SRAS and AD, we have a problem. High production can strain resources and labor is working overtime. This will cause workers to ask for an increase in wages and cause supply to go down. This will then cause a decrease in aggregate supply (SRAS1 to SRAS) bringing the economy back to long-run equilibrium.

This is how the economy self corrects itself after a short-run increase in aggregate supply. After the long-run adjustment the price level will be brought up to P1. Inflation is the direct result of this long-term adjustment. If SRAS didn’t correct on its own, we wouldn’t have inflation. So in order to fix inflationary gaps without inflation, there are things called fiscal and monetary policies that fix the issue in a different way.