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ECON102 > Week 23 - Aggregate Demand, Aggregate Supply, Inflation > Flashcards

Week 23 - Aggregate Demand, Aggregate Supply, Inflation Flashcards

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1
Q

What does the Aggregate Demand (AD) curve show?

A

The relationship between short-run equilibrium output Y and the rate of inflation π.

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2
Q

What determines short-run equilibrium output in the context of the AD curve?

A

Total planned spending in the economy.

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3
Q

Why is the Aggregate Demand curve downward-sloping?

A

Because increases in inflation reduce planned spending, which lowers short-run output.

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4
Q

What does a point on the AD curve represent?

A

The level of output where planned spending equals actual output at a given inflation rate.

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5
Q

What does the Keynesian model assume about prices in the short run?

A

That output adjusts to demand while prices are preset.

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6
Q

Do prices remain fixed forever in the Keynesian model?

A

No, prices are only sticky in the short run and adjust over time.

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7
Q

What limitation does the Keynesian model have regarding inflation?

A

It does not explain the behaviour of inflation.

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8
Q

What largely explains the downward slope of the Aggregate Demand curve?

A

The Fed’s reaction function (e.g., Taylor Rule), where rising inflation leads to higher real interest rates, reducing spending and output.

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9
Q

How does the Fed’s response to inflation influence output?

A

Higher inflation prompts the Fed to raise interest rates, which decreases consumption and investment, lowering output.

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10
Q

How do distributional effects contribute to the downward slope of the AD curve?

A

Inflation hurts lower-income individuals more, and since they spend a higher portion of their income, total output Y falls when their spending decreases.

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11
Q

How does uncertainty from inflation affect aggregate demand?

A

Inflation increases uncertainty about future prices, leading households and firms to reduce or delay spending.

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12
Q

How do exports respond to domestic inflation?

A

Higher inflation raises the prices of exported goods, making them less competitive internationally and reducing net exports.

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13
Q

What does the Aggregate Demand (AD) curve illustrate?

A

The inverse relationship between inflation π and output Y, holding other factors constant.

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14
Q

What happens to output Y when inflation π increases, according to the AD curve?

A

Output Y decreases.

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15
Q

What kind of slope does the AD curve have and why?

A

It slopes downward because higher inflation reduces spending and output.

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16
Q

In a graph with π on the vertical axis and Y on the horizontal axis, how does the AD curve appear?

A

It slopes downward from left to right.

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17
Q

What happens when inflation π increases along the AD curve?

A

Real interest rate r rises → planned spending decreases → output Y falls.

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18
Q

What causes a movement along the AD curve?

A

A change in the inflation rate
π, holding other factors constant.

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19
Q

What is the relationship between inflation π and output Y on the AD curve?

A

Inverse relationship: as
π increases, Y decreases.

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20
Q

What causes the AD curve to shift?

A

Any change in output Y at a given inflation rate π.

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21
Q

What factors can shift the AD curve?

A

Changes in exogenous spending (like government spending or net exports)

Changes in the Fed’s policy reaction function (e.g., adjusting how strongly it reacts to inflation)

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22
Q

What is exogenous spending?

A

Spending that is unrelated to output Y or the real interest rate r, such as government spending, technological innovation, or foreign demand.

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23
Q

How does an increase in exogenous spending affect the AD curve?

A

It shifts the AD curve to the right (from AD to AD′).

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24
Q

What happens to output Y when the AD curve shifts right due to higher exogenous spending?

A

Output Y increases at every inflation rate π.

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25
What are examples of exogenous spending that can shift the AD curve?
Fiscal policy (e.g., government stimulus) Technological improvements Increased foreign demand for domestic goods
26
What does the Fed's policy reaction function describe?
How the Fed sets the real interest rate r in response to changes in inflation π
27
What happens when the Fed "tightens" monetary policy?
It increases the real interest rate r at each level of inflation π, leading to lower planned spending.
28
How does a tightening of monetary policy affect the AD curve?
It shifts the AD curve to the left (from AD to AD′), not right — because higher r reduces output Y.
29
What does the shift from the old to the new policy reaction function represent?
A change in how aggressively the Fed raises interest rates in response to inflation.
30
What is the result of a higher real interest rate r from tighter Fed policy?
Lower consumption and investment → reduced aggregate demand → lower output Y.
31
What happens to inflation when the economy operates at potential output Y* with no external shocks?
Inflation remains roughly constant—this is known as inflation inertia.
32
What is inflation inertia?
The tendency for inflation to change slowly over time in the absence of large shocks.
33
Why does inflation show inertia in industrial economies like the U.S.?
Inflation expectations—people and firms plan for expected inflation. Long-term wage and price contracts—agreements that lock in prices/wages for future periods.
34
How does inflation inertia affect short-run aggregate supply (SRAS)?
It makes SRAS relatively stable, unless disrupted by major shocks or policy changes.
35
Why do inflation expectations matter in wage and price setting?
Because wages and prices for future transactions are negotiated based on expected inflation.
36
What happens if people expect high inflation?
They will agree to higher wages and prices now, which can actually cause inflation to rise.
37
How can inflation expectations become self-fulfilling?
If everyone expects inflation, they build it into contracts—causing actual inflation to occur.
38
How do expectations contribute to inflation inertia?
Because expectations are slow to adjust, inflation tends to change gradually unless disrupted.
39
How long do union wage contracts typically last?
They often set wages for several years.
40
What other types of contracts are typically long term like union wages?
Contracts for raw materials and parts used by manufacturing firms.
41
What do long-term contracts reflect about inflation?
They are based on inflation expectations at the time the contracts are signed.
42
How do long-term contracts contribute to inflation inertia?
By locking in prices and wages based on past expectations, making inflation slow to change.
43
What is the first step in the virtuous circle of low inflation?
Low inflation.
44
How does low inflation lead to low expected inflation?
When inflation is consistently low, people expect it to remain low, shaping their future inflation expectations.
45
What happens when expected inflation remains low?
Wages and production costs increase slowly.
46
How does slow wage and cost increases contribute to the virtuous circle?
They help maintain low inflation, reinforcing the cycle of low expected inflation.
47
What are three factors that can increase the inflation rate?
Output gap Inflation shock Shock to potential output
48
What happens to inflation when there is no output gap (Y=Y*)?
Inflation remains unchanged.
49
What happens to inflation in an expansionary gap (Y>Y*)?
Inflation rises.
50
What happens to inflation in a recessionary gap (Y
Inflation falls.
51
What is an expansionary gap?
When actual output exceeds potential output, leading to rising inflation.
52
What is a recessionary gap?
When actual output is less than potential output, leading to falling inflation.
53
What does the Long-Run Aggregate Supply (LRAS) curve represent?
It is a vertical line showing the economy’s potential output Y*, where the economy is at full employment.
54
What does the Short-Run Aggregate Supply (SRAS) curve represent?
It is a horizontal line showing the current rate of inflation, as determined by past expectations and pricing decisions.
55
How does the LRAS differ from the SRAS?
The LRAS is vertical, reflecting potential output, while the SRAS is horizontal, reflecting the short-run relationship between inflation and output.
56
What determines the position of the SRAS curve in the short run?
The current inflation rate, which is influenced by past expectations and pricing decisions.
57
What defines short-run equilibrium in the AD-AS model?
Short-run equilibrium occurs when inflation equals the rate determined by past expectations and pricing decisions, and output equals the level of short-run equilibrium output consistent with that inflation rate.
58
Where is short-run equilibrium represented on the AD-AS diagram?
It occurs at the intersection of the AD curve and the SRAS curve.
59
What defines long-run equilibrium in the AD-AS model?
Long-run equilibrium occurs when actual output equals potential output (Y*) and the inflation rate is stable.
60
Where is long-run equilibrium represented on the AD-AS diagram?
Long-run equilibrium occurs when the AD curve, SRAS curve, and LRAS line all intersect at a single point.
61
What does point A represent in the AD-AS diagram?
Point A is the short-run equilibrium where the SRAS curve intersects the AD curve, with output Y less than potential output Y*, indicating a recessionary gap
62
What happens when there is a recessionary gap (Y
Inflation π decreases and output Y increases as the economy adjusts toward long-run equilibrium.
63
What does long-run equilibrium (point B) represent in the AD-AS diagram?
Long-run equilibrium occurs when the AD, SRAS, and LRAS curves all intersect at the same point, with output Y equal to potential output Y* and inflation π stable.
64
What does the LRAS curve represent in the AD-AS model?
The LRAS curve is a vertical line at potential output Y*, showing the economy's full employment level of output in the long run.
65
What happens when firms are selling less than they want in a recessionary gap?
Firms start to lower prices.
66
How does the Fed respond to a recessionary gap?
The Fed lowers the real interest rate r, which increases aggregate demand (AD).
67
How does falling inflation (π) affect the economy in a recessionary gap?
Falling inflation reduces uncertainty, which increases aggregate demand (AD).
68
How does an increase in output (Y) impact unemployment?
As output increases, cyclical unemployment falls, according to Okun’s law.
69
What happens at the end of the adjustment process in a recessionary gap?
The economy continues adjusting until long-run equilibrium is reached, where AD, SRAS, and LRAS all intersect.
70
What happens when a recessionary gap exists in the AD-AS model?
Output is less than potential output Yπ*).
71
What happens to the SRAS curve during the adjustment process?
The SRAS curve shifts rightward (from SRAS to SRAS') as inflation decreases and adjusts toward the long-run rate π *
72
Where is long-run equilibrium reached in the AD-AS model?
Long-run equilibrium is reached at Point B, where the AD, SRAS (at π*), and LRAS curves all intersect at the same point, with output Y=Y* and inflation π = π*
73
What is the significance of Point A in the AD-AS model?
Point A represents the short-run equilibrium, where AD intersects SRAS, but output is less than potential output, and inflation is above the long-run inflation rate.
74
What is an expansionary gap in the AD-AS model?
An expansionary gap occurs when output Y is greater than potential output Y*, leading to an increase in inflation.
75
What happens to inflation and aggregate demand (AD) when an expansionary gap exists?
Inflation (π) rises, and aggregate demand (AD) falls, causing output (Y) to decrease.
76
What happens to the SRAS curve during an expansionary gap?
The SRAS curve shifts to the left (from SRAS to SRAS') as inflation increases.
77
Where is long-run equilibrium reached in the AD-AS model during an expansionary gap?
Long-run equilibrium is reached at Point B, where the AD, SRAS (at π*), and LRAS curves all intersect at the same point, with output Y=Y* and inflation π = π*
78
Does the Keynesian model include a self-correcting mechanism?
No, the Keynesian model does not include a self-correcting mechanism.
78
What does it mean that the economy is self-correcting in the long run?
In the long run, the economy tends to be self-correcting.
79
What does the Keynesian model focus on?
It concentrates on the short run with no price adjustment.
80
What does the self-correcting mechanism focus on?
It concentrates on the long run with price adjustments.
81
What characterises a slow self-correcting mechanism in the economy?
Fiscal and monetary policy can help stabilise the economy.
82
What characterises a fast self-correcting mechanism in the economy?
Fiscal and monetary policy are not effective and may destabilise the economy.
83
What factors influence the speed of economic self-correction?
The use of long-term contracts and the efficiency and flexibility of labour markets.
84
When are fiscal and monetary policies most useful?
When attempting to eliminate large output gaps.

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