Aggregate Demand and Aggregate Supply

Question 1

What is the business cycle?

Answer 1

periods of economic expansion and
economic contraction relative to the trend rate of economic growth

Question 2

What is the expansion phase?

Answer 2

a phase in the business cycle where production, employment and income are
increasing above trend growth.

Question 3

What is the contraction phase?

Answer 3

a phase in the business cycle where production, employment and income are falling below trend growth.

Question 4

What is a recession?

Answer 4

2 successive quarters where production, employment and income are decreasing and
the rate of economic growth is negative

Question 5

What is a recessions impact on the inflation rate?

Answer 5

when recession comes, inflation decreases

Question 6

What is a recessions impact on the unemployment rate?

Answer 6

when recession comes, unemployment increases, and continues in the early stages of recovery (usually)

Question 7

What causes recessions?

Answer 7

Caused by a shock

Question 8

What is the Aggregate demand and aggregate supply model?

Answer 8

A model that
explains short-run fluctuations in real GDP and the price level.

Question 9

How do you determine the Real GDP and price level?

Answer 9

intersection of the aggregate demand curve and the short-run
aggregate supply curve.
12

Question 10

What is the aggregate demand curve

Answer 10

A curve that shows the
relationship between the price level, the quantity of real GDP
demanded by households, firms and the government, plus net
exports.

Question 11

Why is the AD curve downward sloping?

Answer 11

The wealth effect
▹ How a change in the price level affects consumption.
▸ The interest-rate effect
▹ How a change in the price level affects investment.
▸ The international-trade effect
▹ How a change in the price level affects net exports.

Question 12

What is defined as moving along the AD?

Answer 12

Changes in the price level

Question 13

What are the reasons for the AD curve to shift left?

Answer 13

• increase in interest rates: (+) cost to firms/households (-) investment/consumption spending
• increase in individual/company income taxes: (-) consumption spending and investment
• increase in growth rate of domestic GDP relative to the growth rate of foreign GDP: (+) imports faster than exports. (-) net exports
• increase in the exchange rate (value of dollar): (+) imports. (-) net export

Question 14

What are the reasons for the AD curve to shift right?

Answer 14

• increase in government purchases: government purchases are a component in AD
• increase in household expectation of their future incomes: (+) consumption spending
• increase in firms expectation of future profitability of investment spending: investment spending increases

Question 15

What is the long run supply aggregate curve?

Answer 15

curve that shows the
relationship in the long run between the price level and the quantity of
real GDP supplied

Question 16

what does the LRAS curve show?

Answer 16

in the long run,
increases in the price level do not affect the level of real GDP

Question 17

What causes shifts in LRAS

Answer 17

▸ An increase in resources.
▸ An increase in machinery and equipment.
▸ New technology.

Question 18

What is the SRAS?

Answer 18

is upward sloping, showing that, in the short run, firms will produce more in response to higher prices.

Question 19

why is the SRAS upward sloping?

Answer 19

The prices of inputs tends to rise more slowly than the prices of final
products.
– Contracts make some wages and prices ‘sticky’.
– Firms are often slow to adjust wages.
– Menu costs make some prices sticky. Menu costs are costs to
firms of changing prices.

Question 20

Reasons for LEFT shift in SRAS

Answer 20

• increase in expected future price level: workers and firms increase wages and prices
• increase in workers and firms adjusting to having previously underestimated the price level: workers and firms increase wages and prices
• increase in expected price of an imported natural resource: cost of producing output rise

Question 21

what are the variables that shift both SRAS and LRAS

Answer 21

▸Increases in the labour force and/or in the capital stock,
and/or in resources.
▸ Technological change

Question 22

How do you find the long run equilibrium?

Answer 22

In long-run equilibrium, the aggregate demand and short-run aggregate
supply curves intersect at a point along the long-run aggregate supply
curve.

Question 23

How do we use the AS and AD model?

Answer 23

▸ Assume economy starts in long run equilibrium
▸ A demand or supply shock hits the economy, shifting either AD
or SRAS depending on the factor
▸ We look at how the short run equilibrium has changed
▸ Through wage and price adjustments, SRAS eventually shifts
and brings us back to long run equilibrium

Question 24

what is supply shock?

Answer 24

An unexpected event that causes the short-run
aggregate supply curve to shift left

Question 25

what is stagflation?

Answer 25

A combination of inflation and recession, usually resulting from a supply shock

Question 26

what is a dynamic AD AS model?

Answer 26

A dynamic aggregate demand and aggregate supply model can be created by making three changes to the basic model: ▸ Potential GDP increases continually, shifting the LRAS curve to the right. ▸ During most years the AD curve shifts to the right. ▸ Except during periods when workers and firms expect high rates of inflation, the SRAS curve shifts to the right.

Question 27

What is the business cycle?

Answer 27

It refers to the alternating periods of economic expansion and contraction relative to the trend rate of economic growth.

Question 28

What happens during an expansion phase?

Answer 28

Production, employment, and income are increasing above trend growth.

Question 29

What happens during a contraction phase?

Answer 29

Production, employment, and income are falling below trend growth.

Question 30

Define a recession.

Answer 30

A significant decline in economic activity lasting more than a few months, visible in industrial production, employment, real income, and trade.

Question 31

What is the technical definition of a recession?

Answer 31

Two consecutive quarters of negative economic growth.

Question 32

What does the AD-AS model explain?

Answer 32

Short-run fluctuations in real GDP and the price level, especially due to economic shocks

Question 33

What are economic shocks?

Answer 33

Sudden events that affect AD or AS, such as changes in oil prices or government policy.

Question 34

What determines short-run real GDP and the price level?

Answer 34

The intersection of the AD and SRAS curves.

Question 35

Why is the AD curve downward sloping?

Answer 35

Due to: Wealth Effect – Higher prices reduce real wealth → ↓ consumption Interest Rate Effect – Higher prices → ↑ interest rates → ↓ investment International Trade Effect – Higher prices → ↓ exports, ↑ imports → ↓ net exports

Question 35

What does the Aggregate Demand (AD) curve show?

Answer 35

The relationship between the price level and the quantity of real GDP demanded by households, firms, the government, and net exports.

Question 36

What causes movements along the AD curve?

Answer 36

Changes in the price level, holding everything else constant.

Question 37

What causes the AD curve to shift?

Answer 37

Government or monetary policy (e.g. changes in interest rates, taxes, spending) Expectations of households/firms about the future Foreign variables (e.g. exchange rates, foreign income)

Question 38

What does the LRAS curve represent?

Answer 38

The relationship in the long run between the price level and real GDP supplied—a vertical line at potential GDP.

Question 39

Why is the LRAS vertical?

Answer 39

In the long run, price level changes do not affect real GDP.

Question 40

What shifts the LRAS curve?

Answer 40

Increases in resources (labour, land, capital) New technology Growth in capital stock

Question 41

What does the SRAS curve show?

Answer 41

A positive relationship between the price level and the quantity of real GDP supplied in the short run.

Question 42

Why is the SRAS curve upward sloping?

Answer 42

Input prices (e.g. wages) are sticky Contracts fix wages/prices in the short run Menu costs discourage frequent price changes

Question 43

What shifts the SRAS curve?

Answer 43

Expected changes in future price level Corrections to past misjudgments of prices Unexpected changes in input costs (e.g. oil shocks)

Question 44

What shifts both SRAS and LRAS?

Answer 44

Increases in the labour force Growth in capital Technological improvements

Question 45

What is long-run equilibrium?

Answer 45

When AD, SRAS, and LRAS all intersect—output is at potential GDP, and there is no pressure for price or output changes.

Question 46

What happens after a demand shock?

Answer 46

In the short run: AD shifts, causing a new SR equilibrium Over time: SRAS adjusts (e.g., via wage changes) → economy returns to long-run equilibrium

Question 47

What is a supply shock?

Answer 47

A sudden change in production costs, shifting the SRAS curve (usually left).

Question 48

What is stagflation?

Answer 48

A situation where inflation and recession occur simultaneously due to a leftward SRAS shift (e.g. oil price shock).

Question 49

How is the dynamic AD-AS model different?

Answer 49

It incorporates: Continually rising potential GDP (shifts LRAS right) AD usually increases over time SRAS increases except during high inflation expectations

Question 50

What happens with positive growth but no inflation?

Answer 50

All curves shift right in parallel → higher GDP, stable price level.

Question 51

What happens with growth and inflation?

Answer 51

AD shifts more than SRAS → GDP increases, but so does the price level.