Aggregate Demand and Aggregate Supply

Question 1

What’s the difference between the Keynesian model and the AD-AS model.

Answer 1

The Keynesian model is only concerned with demand assuming that the price level remains the same. Whereas, the AD-AS model includes aggregate supply (consumer decisions) and varying price level.

Question 2

What is meant by Aggregate Demand?

Answer 2

Total quantity of goods and services demanded at different price levels. The AD curve gives a level of output where AE=Y for each price level.

Question 3

What causes a movement along the AD curve?

Answer 3

The price level causes movement along the AD curve, of which the AD curve is downward sloping.

Question 4

What causes a shift in the AD curve?

Answer 4

World economy: exchange rates and foreign national income.
Expectations: spending
Fiscal policy: taxes
Monetary policy: interest rates and money supply.

Question 5

What is aggregate supply?

Answer 5

The total quantity of goods and services supplied at different price levels.

Question 6

What do firms production decisions depend on? What is the Aggregate production function?

Answer 6

Labor, Capital and Technology
Aggregate production function:
F( L,K,T)

Question 7

Difference between short run aggregate supply and long run aggregate supply

Answer 7

Short run: inputs are fixed and output will change according to changes in the price level.
Long run: inputs will change according to changes in the price level but outputs are fixed.

Question 8

How does the Short Run Aggregate Supply curve (SRAS) work?

Answer 8

The higher the price level the higher the output due to higher profits in the short run with the fixed costs of production. Alternatively, a lower price level causes firms to produce less because it results in less profits.

Question 9

How does the Long Run Aggregate Supply curve (LRAS) work?

Answer 9

In the long run inputs adjust to changes in the price level and output does not depend on the price level as it is undetermined what they may be.

Question 10

What is the level of real GDP that an economy produces in the long run?

Answer 10

Potential GDP

Question 11

Movements along the SRAS and LRAS

Answer 11

In the short run, firms respond to the change in price level by either an increase (moving right) or a decrease (moving left) in the output.
In the long run, inputs change depending on the price level, but real GDP remains the same (no way to determine output) therefore it will move up or down the line.

Question 12

How does long-run macroeconomic equilibrium work?

Answer 12

Where Potential GDP intersects with AD as price level is arbitrary.

Question 13

How does an inflationary or recessionary gap occur?

Answer 13

When potential GDP is greater than actual GDP it is a recessionary gap.
When actual GDP is greater than potential GDP it is an inflationary gap.

Question 13

What happens subsequently to a recessionary gap and inflationary gap and the process of being brought back to equilibrium?

Answer 13

An inflationary gap means firms are using factors of production a rate higher than the normal utilization rate. This excess demand for labor results in wages to increase, subsequently increasing their cost per unit. As a result, SRAS shifts to the left.

A recessionary gap means that firms are not using the factors of production at full capacity. The excess supply of labor pushes wages down and firms cost per unit to decrease. As a result, SRAS shifts to the right.

Question 14

How else will the economy reach potential GDP without the adjustment in wages?

Answer 14

Government interventions and the central bank

Question 15

What are economic shocks?

Answer 15

They unexpectedly affect the economy by changing aggregate supply, aggregate demand or both.

Question 16

What are expansionary AD shocks?

Answer 16

This is when the AD curve shifts right because of lower taxes, higher government spending, investment or net exports. This causes an inflationary gap as Actual GDP > Potential GDP, making there excess demand for workers, causing wages to decrease and shifting the SRAS curve to the left. In the end this causes the price level to increase.

Question 17

What are contractionary AD shocks?

Answer 17

This is when the AD curve shifts to the left because of higher taxes, lower government spending, investment or net exports. This causes a recessionary gap as potential GDP is higher than actual GDP, making there excess supply for workers and shifting the SRAS curve to the left. In the end this causes the price level to decrease.

Question 18

What are positive or negative supply shocks?

Answer 18

Supply shocks can only be positive or negative.
A positive supply shock is a rightward shift because of a decrease in wages or an increase in technology.
A negative supply shock is a leftward shift because of an increase in wages or a decrease in technology. Either way they both go back to the original points as the process of inflationary gap or recessionary gap takes place. No change to LRAS (as always) and same with price level.

Question 19

What are automatic stabilizers and give examples?

Answer 19

Buffers that lessen the extent to which actual GDP differs from potential GDP without any deliberate interventions by the government or central bank. This can be either unemployment benefits or income assistance.
For example, income assistance to the unemployed when unemployment rises makes it so people have more disposable income, diminishing the magnitude of the recessionary gap.
Also, when the economy expands and income rises, income taxed collected go up too so that disposable income does not increase as much as it would otherwise, diminishing the effect of an inflationary gap.

Question 20

What are the side effects of automatic stabilizers?

Answer 20

Government budget deficits increase during a recession because government unemployment payments rise and tax revenues fall.

Question 21

What are sticky (rigid) wages and why do they happen?

Answer 21

Sticky and rigid can be used interchangeably.
Sticky wages explain why recessionary gaps may persist in the short run because nominal wages are slow to adjust to market forces.
Nominal wages are slow to sticky because of union wages, government regulation, efficiency wages, implicit and explicit contracts (workers are paid by a contract unable to adjust until it reaches the end).