Chapter 11: Aggregate Demand and Aggregate Supply

Question 1

Define ‘Aggregate demand curve’.

Answer 1

A curve that shows the relationship between the overall price level in the economy and total demand.
Composed of all the components of expenditure in the economy: consumption, investment, government spending, and net exports.

Question 2

Define ‘Aggregate supply curve’.

Answer 2

A curve that shows the relationship between the overall price level in the economy and total production by firms.

Question 3

Define ‘Business cycle’.

Answer 3

Fluctuations of GDP either above or below the potential level of GDP in the economy.

Question 4

Define ‘Supply shock’.

Answer 4

Significant event that directly affects production and the aggregate-supply curve in the short run.

Question 5

Why is the aggregate demand curve downward sloping?

Answer 5

Because consumption, investment, and net exports all decline when the price level rises.

Question 6

Why is short-run aggregate supply curve upward-sloping?

Answer 6

Because it takes some time for input prices and/or wages to adjust.
In the short run, the economy responds to changes in the price level by increasing or decreasing output.

Question 7

In the long run, production is determined by the availability of inputs for production and the technology to convert inputs to outputs (factors of production?). In the long run, there is ___ relationship between the price level and output.

Answer 7

No.

Question 8

Where does the long-run equilibrium occur?

Answer 8

At the intersection of the aggregate demand and long-run aggregate supply curves.

Question 9

What happened to Canada in 2008 and what was the government’s response?

Answer 9

• 2008 recession, shifting aggregate demand curve to left

- Government introduced 2009 stimulus package to shift aggregate demand curve back out, stimulate output and employment

Question 10

What are some factors that could cause the aggregate demand curve to shift?

Answer 10

Since the aggregate demand curve is derived from the definition of GDP - Y = C+I+G+NX - anything that affects any of the components of GDP will shift the aggregate demand curve.
I.e. increase in G curve will shift out; decrease in NX, curve will shift in.

Question 11

What happens when the aggregate demand curve shifts?

Answer 11

There will be a short-run change in output, but no long-run shift in output. The price level will change in both the short run and long run.

Question 12

What is the difference between the SRAS and LRAS?

Answer 12

• LRAS shows what economy can produce if all the factors of production are being utilized. Doesn’t depend on prices, so vertical.
• SRAS is upward-sloping curve between prices and output. Factors that affect only the cost of production and do not change the amount of factors available for production, will only shift the SRAS curve.

Question 13

What are some factors that cause a shift in the SRAS?

Answer 13

• If the prices of inputs change, the entire aggregate supply curve will shift
• Any change that makes production more expensive for firms will shift the curve in (left)
• Any change that makes production cheaper for producers will shift the curve out (right)

Question 14

What are some factors that cause a shift in the LRAS?

Answer 14

• If the potential output of the economy expands, the LRAS will shift out
• If the production possibilities frontier for the economy contracts, the LRAS will shift in.

Question 15

What are the short-run and long-run effects of a shift in aggregate demand?

Answer 15

• Positive shock: Price and output increase in short-run. Eventually, input prices and wages catch up. The SRAS slowly adjusts to the right. In the end, prices increase further while output falls back to original level.
• Negative shock: Demand shifts to left. Prices and output fall. Adjustment of SRAS to right brings output back to original levels, but prices fall further.

Question 16

What is a permanent supply shock?

Answer 16

Anything that affects the factors of production or the level of technology will affect both the LRAS and SRAS curve.
Both the price level and output change in long-run.

Question 17

What is a temporary supply shock?

Answer 17

Anything that affects the prices of inputs or the costs of doing business will affect the SRAS curve, but not the LRAS curve.
The price level and output changes in short-run, but not in long run.

Question 18

What are the policy options the gov. can use to counteract supply and demand shocks?

Answer 18

• Depending on type of shock, government can increase or reduce gov. spending
• Shortfalls in aggregate demand can be corrected by increased spending
• Same is true of supply, but must be more careful
• Action is preferable to waiting sometimes, but regardless of shock, increases in gov. spending produce higher prices in long-run

Question 19

What is the wealth effect?

Answer 19

Rise in overall price levels decrease people’s wealth in terms of real purchasing power. When people are less wealthy, they reduce their consumption, creating a (-) relationship between overall price level and consumption spending.