Aggregate Demand and Aggregate Supply (AD/AS) Model

Question 1

What is the AD/AS model used for?

Answer 1

It is a key macroeconomic framework used to explain the interplay between aggregate demand and supply, particularly in analyzing fiscal and monetary policy impacts.

Question 2

What is the key question analyzed by the AD/AS model?

Answer 2

Does expansionary policy increase output and jobs (reflationary) or cause inflation?

Question 3

What are the two types of aggregate supply in the AD/AS model?

Answer 3

Short-run aggregate supply (SRAS) and long-run aggregate supply (LRAS).

Question 4

What is aggregate demand (AD)?

Answer 4

Total planned spending on goods and services within an economy over a time period.

Question 5

What is the equation for aggregate demand?

Answer 5

𝐴𝐷=𝐶+𝐼+G+(𝑋−𝑀), where:
* C: Consumption (households)
* I: Investment (firms)
* G: Government spending
* X−M: Net exports (exports minus imports)

Question 6

What is the difference between AD and national expenditure?

Answer 6

AD is planned spending, while national expenditure is actual spending.

Question 7

What is the shape of the AD curve?

Answer 7

Downward sloping, showing an inverse relationship between price level and planned real output.

Question 8

What causes shifts in the AD curve?

Answer 8

Changes in factors other than price level, such as consumer confidence, fiscal policy, or monetary policy.

Question 9

What are the reasons the AD curve slopes downward?

Answer 9

1. Wealth Effect: Lower price levels increase real money balances, encouraging spending.
2. Interest Rate Effect: Lower price levels reduce interest rates, stimulating investment and consumption.
3. Net Export Effect: Lower domestic price levels make exports more competitive and imports less attractive, increasing net exports.

Question 10

What is short-run aggregate supply (SRAS)?

Answer 10

Planned production/output at various price levels, assuming fixed input costs like wages.

Question 11

What is the shape of the SRAS curve?

Answer 11

Upward sloping; becomes steeper as output approaches full capacity.

Question 12

What causes the SRAS curve to shift leftward?

Answer 12

Rising production costs, such as higher wages, raw material costs, or taxes.

Question 13

What causes the SRAS curve to shift rightward?

Answer 13

Falling production costs or increased productivity.

Question 14

Why does the SRAS curve slope upward?

Answer 14

Rising output leads to diminishing marginal productivity, which increases marginal costs, requiring higher prices for more production.

Question 15

How do changes in the money wage rate affect the SRAS curve?

Answer 15

• Increase: Raises production costs, shifting SRAS left.
• Decrease: Lowers production costs, shifting SRAS right

Question 16

What is the shape of the non-linear SRAS curve?

Answer 16

• Horizontal at low output (spare capacity).
• Steeper as output rises due to capacity constraints.
• Vertical at full capacity

Question 17

What does the LRAS curve represent?

Answer 17

The maximum sustainable level of real output (𝑌𝑛) an economy can produce when all factors of production are efficiently employed.

Question 18

Where is the LRAS curve located?

Answer 18

At the economy’s production possibility frontier (PPF), reflecting ‘normal capacity’ output, which is slightly below ‘full capacity’ output?

Question 19

What is long-run macroeconomic equilibrium?

Answer 19

It occurs where LRAS intersects aggregate demand (AD) and short-run aggregate supply (SRAS).

Question 20

What is the difference between ‘normal capacity’ and ‘full capacity’?

Answer 20

• Normal Capacity: Sustainable production level without inflationary pressures or overuse of resources.
• Full Capacity: Maximum output achievable temporarily through overtime, higher factor inputs, or short-term measures.

Question 21

What happens when an economy operates above normal capacity?

Answer 21

It creates a positive output gap, leading to inflationary pressures and a wage-price spiral.

Question 22

What is the adjustment mechanism for a positive output gap?

Answer 22

• AD increases, causing SRAS to allow temporary production beyond 𝑌𝑛.
• Excess demand for labour and inputs creates shortages.
• Wages and input costs rise, shifting SRAS leftward.
• Real output returns to 𝑌𝑛 as inflation adjusts the economy to long-run equilibrium.

Question 23

How do the Keynesian and Neoclassical LRAS curves differ?

Answer 23

Neoclassical: Vertical at 𝑌𝑛, markets are self-correcting with competitive full employment in the long run.
Keynesian:
* Horizontal section: Spare capacity; output increases without price level changes.
* Upward sloping section: Scarce resources cause rising output and price levels.
* Vertical section: Full employment reached; output is capped at 𝑌𝑛.

Question 24

What does the Neoclassical LRAS curve emphasise?

Answer 24

Supply-side determinants like technological advancement, labour productivity, and market efficiency.

Question 25

What is the Keynesian critique regarding the LRAS?

Answer 25

Demand-side failures can cause persistent underemployment, necessitating government intervention through fiscal policy.

Question 26

What are the determinants of LRAS?

Answer 26

**1. Quantity and Quality of Factors of Production**: Labour: Workforce size, skills, and productivity. Capital: Infrastructure, technology, machinery. Land: Natural resource availability. Technological Progress: Increases productivity. **2. Institutional Factors**: Market efficiency, legal frameworks. **3. Government Policies**: Supply-side reforms, infrastructure investment

Question 27

Provide examples of supply-side policies that influence LRAS.

Answer 27

Training programs, tax incentives for investment, deregulation, and spending on infrastructure.

Question 28

What is a positive output gap?

Answer 28

When actual output exceeds potential output, causing inflationary pressures.

Question 29

What is a negative output gap?

Answer 29

When actual output is below potential output, leading to unemployment and underutilised resources.

Question 30

What is the wage-price spiral?

Answer 30

Rising wages increase production costs, causing inflation, which leads to further demands for higher wages.

Question 31

How does the Phillips Curve relate to LRAS in the long run?

Answer 31

In the long run, there is no trade-off between unemployment and inflation, consistent with a vertical LRAS.

Question 32

What evidence supports the Keynesian perspective on LRAS?

Answer 32

* **Great Depression (1930s)**: Persistent underemployment despite falling prices. * **Post-2008 Financial Crisis**: Demand-side policies reduced output gaps

Question 33

What evidence supports the Neoclassical perspective on LRAS?

Answer 33

* Focus on supply-side policies (e.g., Reaganomics, Thatcherism) enhancing productivity and reducing inflationary pressures.

Question 34

What are the policy implications of the Neoclassical and Keynesian LRAS views?

Answer 34

* **Neoclassical**: Structural reforms to shift LRAS outward. * **Keynesian**: Demand-side interventions during underemployment

Question 35

What dynamic factors cause LRAS to shift over time?

Answer 35

Changes in demographics, technological innovation, and education.

Question 36

What are critiques of the Neoclassical and Keynesian approaches to LRAS?

Answer 36

* **Neoclassical**: Overestimates market efficiency. * **Keynesian**: Risks crowding out private investment and increasing public debt.

Question 37

What is hysteresis?

Answer 37

Prolonged downturns can reduce long-run potential output, causing the LRAS to shift left.

Question 38

What is stagflation?

Answer 38

Simultaneous inflation and stagnation due to adverse supply shocks.

Question 39

What does the Phillips curve describe?

Answer 39

A short-run trade-off between unemployment and inflation, linked to AD/AS dynamics.

Question 40

What is the multiplier effect in fiscal policy?

Answer 40

Fiscal policy-induced AD changes amplify economic output through secondary spending cycles.

Question 41

How do policies differ in their effectiveness based on SRAS?

Answer 41

* **Horizontal SRAS**: Expansionary policies are more effective in economies with spare capacity. * **Vertical SRAS**: Such policies become inflationary under full capacity conditions.

Question 42

Provide an example of a leftward SRAS shift.

Answer 42

The 1970s stagflation due to oil shocks.

Question 43

Provide an example of AD-side policy focus.

Answer 43

The 2008 global financial crisis emphasized stimulus policies to combat demand deficiency.