week 10

Question 1

ad-as model

Answer 1

• basic assumptions
• > time horizon is longer than in the keynesian model
• > price and output can change over time
• > used to analyse fluctuations

Question 2

aggregate demand

Answer 2

• relationship between inflation (pie) and short run equilibrium output (Y)
• downward sloping

Question 3

inflation, rba and ad curve

Answer 3

• RBA plays a major role in explaining the AD curve

- Increase inflation -> Increase R -> decrease expenditure -> decrease Y

Question 4

Slope of the AD

Answer 4

• Reserve bank reaction function: highr inflation inplies higher inflation rate
• Exports effect: increases in the price of domestic goods sold abroad
• wealth effect: decrease spending when they experience a decrease in their wealth’s purchasing power
• distributional effects: the poorer spend greater percentage of their income than the wealthier
• uncertainty: consumers and firms spend less in an uncertain environment

Question 5

what causes the ad curve to shift?

Answer 5

• exogenous changes in C I G NX
• e.g. at a given rate of x, one or more components of PAE decreases
• causes a drop in production and AD1 decreases to AD2

Question 6

shifts of the ad curve - policy reaction function

Answer 6

• -upward shift in the policy reaction function indicates the RBA is raising the real interest rate for each level of inflation

Question 7

long run aggregate supply line

Answer 7

• LR, the quantity of output supplied depends on the economy’s K and L and technology for turning these inputs into outputs
• does not depend on inflation rate

Question 8

inflation and output gaps

Answer 8

• if Y=Y*(Potential), there is no incentive for the firm to increase its price relative to prices of other goods
• inflation rate tend to remain the same

Question 9

Y>Y*

Answer 9

• Expansionary output gap
• where sales exceed normal production rates
• firms will increases their prices by more than their costs,
• inflation rate increases

Question 10

• Self correcting economy

Answer 10

• ad/as model implies that the economy exhibits a self correcting property
• output gaps can be closed through rising or falling inflation - naturally occuring
• keynesian model does not include a self-correcting mechanism

Question 11

How long is long run

Answer 11

• larger the initial output gap, the longer the adjustment time

Question 12

a shift in AD- Weak demand

Answer 12

• initially economy is at long run equilibrium

- pessimism waves overtake economy, ad falls

Question 13

insufficient spending and policy responses

Answer 13

• adopt fiscal policy to increase G / reduce T and shift the AD curve to the right
• Change monetary policy’ reduce cash rate -> shift right

Question 14

inflation shocks

Answer 14

• Inflation increases, SRAS shifts up to SRAS’
• Output falls at short run equilibrium B
• Existence of recessionary gap, inflation begins to drift downward
• Eliminated at A

Question 15

Inflation shocks and RBA

Answer 15

• If RBA aggressively shifts the reaction function, AD curve would be shifted to right
• Y* realised faster but at a higher rate of inflation

Question 16

Shocks to potential output

Answer 16

• Starting at A
• > a sharp rise in the price of oil could affect the economy’s potential output
• Reduction in the capital stock will shift the LRAS to left
• Reduced capacity to meet demand = expansionary gap
• Higher inflation rate
• > RBA can increase interest rate, pushing AD to left
• Inflation is stable in short run but higher levels of unemployment and smaller output

Question 17

summary

Answer 17

• ad/as has 3 components, SRAS, LRAS, Downward sloping AD
• SR.E. = AD intersects SRAS
• LR.E. = AD interesects LRAS
• economy has tendency to correct itself back to its long-run equilibrium
• AD-AS Diagram showcases dilemma facing the RBA; trade off b/w inflation and output