Circular Flow, Measure + Aggregate Demand, Supply Flashcards

Question

Aggregate supply and equilibrium

Answer 1

SRAS (SR meaning short run [can only influence one FOP]) will look much like our microeconomics view of supply LRAS (LR meaning long run) will be a little more complex, as it brings in competing economic theories Aggregate supply is flexible wage and price period (how long does it take for flexible wages to adjust in an economy?) LRAS illustrates the relationship between the avg price level and the level of output in the flexible-wage and price period, which is the period of time following a change in AD over which all wages and prices in the economy can adjust to the level of demand (before that time is what we call short run)

Answer 2

The total quantity of goods and services produced in an economy (real GDP) over a given period of time at different price levels

Answer 3

In the period when resource prices (mostly wages) do not change Just like supply, AS is impacted by: the costs of FOPs government policy We will draw our SRAS, as a straight line (for now) Factors that shift: Changes in wages Changes in non-labour resource prices Changes in indirect taxes Changes in subsidies offered to businesses Supply shocks All of these changes impact the costs of production

Answer 4

Decreases in AD lead to lower pricing and a lower level of output—a recessionary or deflationary gap Increases in AD lead to higher pricing and a higher level of output—an inflationary gap Increases in AS lead to lower pricing and a higher level of output—higher GDP with a lower price level Decreases in AS lead to higher pricing and a lower level of output—recession with inflation, or “stagflation”

Answer 5

There are two different “schools of thought” concerning the shape of the LRAS (new classical/monetarist and Keynesian)

Answer 6

Classical (1800s): Smith + marginal utility, value Wages would self-adjust so cycles would correct themselves Keynesian (1930s): Keynes During a period of high unemployment wages were ‘sticky downwards’ so they could not fall easily for firms to then higher more labour at a cheaper price, demand would also remain low and thus government intervention would be needed in the form of govt spending in order to boost the economy Monetarist/New (Neo) Classical (1970s): Friedman, Lucas Driven by “stagflation” which the Keynesian approach was not equipped to address Importance of market-based supply side policies Adam Smith, people added on, classical economics Great Depression (‘30s): at beginning, people said markets would correct themselves, but they didn’t, which led to the Keynesians, who said there was a flaw and we needed to come up w/ a new theory Keynesians didn’t exist until people saw that the Monetarist theory wasn’t working Government spending became the way to do it

Answer 7

The LRAS curve is perfectly inelastic at the “full employment level of output (this is not zero unemployment) Potential output is based purely on the quantity and quality of the factors of production and NOT the price level (therefore, the LRAS is independent of and doesn’t change depending on the price level) Why is the LRAS vertical? Since wages (and other resource costs) are now changing to match output price changes, the firm’s costs of production remains constant even as the price level changes. As price level increases or decreases, with constant real costs, profits are also constant, and firms no longer have incentive to increase or decrease output Price increases in the short run are fully offset by cost increases in the long run. ex. you own a business making classroom desks: the price level increases, so you are incentivized to increase supply (you move upward along the SRAS curve). In the long run though, wages and other input costs also go up. In the net, nothing has changed for you: your price is higher, but so are your costs Downward-sloping AD curve, upward-sloping SRAS curve New classical monetarist approach Wages will come down w/ prices (lower output means people will probably be let go, and companies should be able to get labor for less) If costs of FOPs go down, supply curve will shift to the right Output goes down, people lose jobs Self-feeding cycle (people can’t buy, more l [great depression] Monetarists say that this is a market at work Neo-classical theory Will bring you back, naturally, to Back to y1, so from an overall producer perspective, we’re okay, assuming that was a good economic level Wages have gone down too, and though they’re paying less for labors, the price levels have gone down Earning less, but paying out less—same problem Same output, but at a lower price in wage level (everyone’s still happy) As a worker, your wage has gone down, but so have prices This whole monetarist view depends on wages coming down

Answer 8

See diagrams... Deflationary Shift from AD1 to AD2 leads to deflationary gap Long run: fall in prices is matched by a fall in wages and other resource costs, leading AD back to the LRAS at an output of Yp We are again at full employment output, but at a lower price level Inflationary Shift from AD1 to AD2 leads to inflationary gap. Long run: increase in prices is matched by a rise in wages and other resource costs, leading AD back to the LRAS at an output of Yp We are again at full employment output, but at a higher price level

Answer 9

During the Great Depression, the world’s economies were not self-correcting Wages were downwardly inflexible since workers were unwilling to accept lower nominal wages, and and unions and government protected worker rights With weak demand, firms had to decrease output and lay off workers A fall in AD below the full-employment level resulted in high unemployment and a large fall in output With C, I, and (X - M) low, the government had to fill the "recessionary gap" by increasing government spending The economy will NOT "self-correct" due to "sticky wages and prices", so government is maintaining full-employment output In the Keynesian view, AS is horizontal below full-employment and vertical beyond full employment Looks like perfectly inelastic supply curve (regardless of price levels, fixed) Sticky downward wages: wages stayed up, so supply curve didn’t shift up (confidence in the economy, yes, but contracts [incomes didn’t change suddenly]) Unions typically have long-term agreements on wages Contractual agreements that are hard to get out of Also the mindset of workers (you don’t wa The Keynesian AS curve shows three possible phases that distinguished between the short and the long run: (1) where AS is perfectly elastic (due to ‘spare capacity’ producers can raise their output without incurring higher average costs e.g. wages) (2) as the economy approaches its potential output, spare capacity is used up and the economy’s FOPs being more scarce (therefore, in order to gain more FOPs and increase output, firms have to pay higher costs—thus the AS curve is upwards sloping) (3) when the economy reaches full capacity, it is impossible to to increase output any further because all FOPs are fully employed (thus, AS is inelastic like the classical LRAS curve) Keynesian theorists do not draw a separate SR and LRAS curve: they show all changes on this curve

Answer 10

Generally, neither view is totally correct Keynes was right in the short-run because wages and prices tend not to adjust quickly to changes in the level of demand The new-classicals are right in the long-run because over time, following a decrease or an increase in AD, wages and prices tend to rise or fall accordingly, causing output in the nation to return to a relatively constant, full-employment level, regardless of the level of AD Neither perfe W/ classical, eventually, but when you have people waiting around to feed their families and stuff, not a good way Empirical evidence that sticky-down wages exist If you’re used to selling at a particular price, (wages haven’t gone down, and you don’t want Neither hrorrible either Times when it’s better to use one or the other— You’ll either be told/given a clear hint, or you can draw either one (if no clear indication)

Answer 11

Relative to the full employment level of output: Deflationary gap shows decreased price and significantly reduced output relative to full employment Inflationary gap shows increased price and small increase in output relative to full employment

Answer 12

See diagrams... An increase in the quality and quantity of factors of production Land, labor, capital, enterprise Qty for each: Reclaim land, build-up, farming techniques, extraction techniques, intensive livestock production, discovery of new resources, increased access to supply of resources Immigration, raising retirement age, lowering working age, encouraging reproduction. Education and training more accessible Increased Investment through ways such as easier access to finance, lower corporate tax Encourage entrepreneurship through enterprise schemes, access to micro credit, start-up incubators etc, attracting FDI Qlty for each: Fertilization, mono-cultures, irrigation, organic farming, sustainable farming, better technology that allows increased access to resources or discovery of new resources Education, training, re-training, apprenticeship programmes Technological advancements, R&D Training, start-up/ business support schemes

Answer 13

Short Draw on a graph AD = SRAS Here the economy is in short-run equilibrium, producing at an output level of Y at the price level of P. The output produced by the economy is exactly equal to the total demand in the economy and there is no upward or downward pressure on the price level. Ceteris paribus, the economy rests at this equilibrium. Long This is where AD=LRAS, as there are two LRAS curves we distinguish between the Keynesian equilibrium output in the long run and the new classical equilibrium output . New Classical - The economy will always move towards its long-run equilibrium at the full-employment level of output. The impact of any changes in AD will be on the price level only. The economy will always move ‘automatically’ (without any government intervention) to its long-run equilibrium. Show an increase in AD on the new classical LRAS curve. In the short-run, an increase in AD will lead to a temporary increase in real output, the economy will be experiencing an inflationary gap, where the economy is in equilibrium at a level of output that is greater than the full employment level of output. This leads to an increase in the price level, which increases the costs of production to firms (labour, raw materials, capital). Thus SRAS shifts back reducing output back to Yfe. The final result is that output returns to its full employment level, but at a higher price of P2. Similarly, in AD falls, In the short-run, a fall in AD will lead to a temporary fall in real output, the economy will be experiencing a deflationary (or recessionary) gap, where the economy is in equilibrium at a level of output that is less than the full employment level of output. This leads to a fall in the price level, which decreases the costs of production to firms (labour, raw materials, capital). Thus SRAS shifts forward, increasing output back to Yfe. The final result is that output returns to its full employment level, but at a lower price of P2. Keynesian - 1. AD = LRAS According to Keynesian economists, the long-run equilibrium level of output may occur at different levels. The equilibrium level of output depends mainly on the level of aggregate demand in the economy. In the Keynesian view, AD can increase such that there is an increase in the level of real output, without any consequent increase in the price level - assuming the economy is experiencing spare capacity and there is a deflationary gap. Show AD increasing at a point on the perfectly elastic section on the Keynesian LRAS curve 2. If AD increases further, the economy will start to experience inflationary pressures as available factors of production become scarcer and their prices are bid up. The price level and real output will both increase. Show this on a graph. 3. If the economy is operating at full employment/ capacity and there is an increase in AD, the outcome will be purely ‘inflationary’. This is because it is impossible for the economy to produce any further increase in output in the long run, given the existing factors of production. Show AD increasing on the perfectly inelastic portion of the LRAS curve.

Answer 14

National income Tell us what’s going on w/ our output and economy If output goes down, employment tends to go down too (don’t need as many people if you’re not making as many things) Bigger incentive to save (get more for leaving in bank), disincentive to borrow/spend (costs more) There’s PMI (there’s a base level, and it’s an indicator of economic growth—is it above or below?)... Crude and refined… Wheat import Fall in value of currency would increase AD (M goes down, X goes up) Mechanics same (logical shifters) A recession is a period when the level of real GDP falls over two quarters (three month periods) in a row Price index/level concerned w/ base year Dividing by something smaller than one will make it grow, so makes sense Whole # if lots of zeros + decimal places, but otherwise, two decimal places Don’t use a taken letter Shift in one, movt along in another? Deflation is a decrease in APL Wages match prices? global income effect (if countries exporting to are more wealthy), tastes + preferences (if ex. Nigerian suya becomes really popular), currency (if depreciates, becomes easier for everyone to buy more of your stuff) If don’t correct, AD losses will keep building on themselves When C and I go down, govts now fairly quickly increase th B/c of interconnectedness of economies, probably in the same place, so imports go down, but countries also wouldn’t want to be buying, so not much difference w/ X and M (not such a big im That’s the monetarist (neo-/new-classical) view LRAS is another view Adam Smith and then newer ones? Limitation on ability to supply Kind of like PPC Given your FOPs and the efficiency w/ which you use them, can’t be outside (unless more FOPs or increased efficiency) Can move LRAS curve if more FOPs or more efficiency W/ expansion, can’t stay there b/c you’re making more than your LRAS says you can (like being outside of the PPC): only a temporary thing you can do to p Wages go up; SRAS shifts to the left, and we’ll be back to a point where we’re at full ecmployment (producing what we did before at a higher price level and higher wages [both producers and workers okay]) Recessionary gap when economy producing less than it should (recession); w/ inflationary gap, extra output causes price level increase Stagflation (stagnant inflation—hard to get rid of) unknown until oil embargo in ‘70s (?); economy in recession, but prices going up (lower output, higher prices) How to deal? Keynesian: recession, so have to spend govt money, but prices will go up even more (makes inflation worse—no one knew what to do [where supply-side of economics came in]) For Keynesian, AS is some exponential-looking thing Vertical portion corresponds to LRAS, so Keynesians agree that at some point, you’ll hit that limit W/ curving part, kind of like SRAS Perfectly elastic supply for first portion Add AD line Shift left Shift again W/ horizontal section, lots of unused resources (potential output is right when starts looking inelastic) Not creating inflation when shifted earlier b/c inexpensive, good-quality FOPs People willing to work As you get closer and closerto full employment level (everyone who’s capable and willing to work is working), the people you’re bringing into thelabor force are more marginal employees (may be less motivated, not have the right skills,...) But if AD shifts out and you want to make more, have to hire them Will spend a lot of time and energy trainign them, but still won’t be as productive (for the additional output they’re giving, cost will be high So, it’s related to scarcity: FOPs becoming more scarce as you Big price level increase for hardly any additional output Inflation becomes bigger w/ every additional increment of output Pushing pricelevels way up for marginal increase in output Just like supply, AS impacted by costs of FOPs and govt policy Basically, all comes down to cost; supply shifts are cost driven Didn’t come down as quickly as monetarists thought they would Govt had to come in and break the downw Led to govt funding everything W/ curve, resources becoming more scarce Just to left of vertical section, we dra LRAS/AS shift b/c of more/better FOPs Like outward expansion of PPC Ceteris paribus Neglects X - M Consumption should equal output if looking at circular flow But if domestically produced, closed Doesn’t account for spending on imports Public sector = govt Is the investment faster than what’s depreciating? X 100 Divide by GDP deflatior in decimal f Deflator goes down = prices went down = deflation Comparing to that year Disinflation is a slowing of Output of different Look at each step of the chain: only recognize what comes from each o Have to subtract input Final link of the chain is ultimate output…(?) in a simple example (more complex) Don’t double-count (subtract input) Policy options, comparison, forecasting (extrapolation to help make decisions [using what’s happening now]) Not just govt (also business) Put yourself in the role of the stakeholder depending on the question When do you start hiring labor, building new factories, buying more FOPs (when economy increasing) When economy reaches peak, may want to hold off on them until Interest rate is the price of money If higher, invest less (b/c costs more to borrow) Incentive to save, disincentive to borrow, spend Factors = determinants For investment, confidence, interest rates, cost of FOPs, debt, income level (parallels consumer) Not investment when not helping the productive capacity of the economy If shares bought are publicly traded, company gets nothign from it, so not investment If company thinks lower th , buy it back, increasing demand and supply If thinks needs more money, Could turn into investment (withdrawal But not investment Even w/ IPO, I B for monetarists and E for Keynesians Operating on LRAS means efficient use of So, B Shift in AD curve for peak (inflation, trying to make more than LRAS) Govt spending is key Keynesian policy Not all govt intervention, just G AD increases w/ I Increasing FOP increases LRAS No impact to AD, but will push out LRAS Think primary Monetarist/Neoclassical is all abt wages (prices go up, wages go up… [?]) Supply-side neoclassical

Circular Flow, Measure + Aggregate Demand, Supply Flashcards

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