Week 24 - Chapter 27: Aggregate demand and supply models

Question 1

Aggregate demand (AD) curve

Answer 1

Shows the relationship between short-run equilibrium output (Y) and rate of inflation (π)
Named as Y is determined by and equals aggregate spending in the economy.

Question 2

Why does the AD curve slope downwards

Answer 2

• Increased inflation reduces planned spending and Y.
• Inflation hurts lower income people more. Lower income people they spend more of their income so when this reduces, so does output.
• Inflation causes uncertainty about future prices so people are more cautious on spending.
• Inflation increases prices of exported goods which lowers exports.

Question 3

Movements along the AD curve

Answer 3

Movement along the AD curve is caused by changes in π or Y.
This is because when π increases -> r increases -> PAE decreases -> Y decreases

Question 4

Shifts of the AD curve

Answer 4

Shifts of the AD curve are caused by any factor that changes Y at a given π.
E.g., changes in exogenous spending or changes to the Feds policy reaction function.

Question 5

Exogenous spending

Answer 5

Spending unrelated to output (Y) or real interest rate (r)
E.g., fiscal policy, technology, foreign demand.

Question 6

Inflation inertia

Answer 6

The tendency for inflation to remain roughly constant, even when economic conditions shift, as long as the economy is operating at Y* and there are no external shocks to the price level.

Question 7

Why does inflation inertia happen

Answer 7

• Inflation expectations: When negotiating wages and prices, inflation expectations can influence decisions e.g., if high inflation is predicted, you will agree to higher prices which can lead to actual inflation as prices rise.
• Long-term wage and price contracts: Long term contracts can set wages or prices of raw materials for several years. These prices will reflect inflation at the time they are signed.

Question 8

What factors can increase inflation rate

Answer 8

• Output gaps: Expansionary gaps increase inflation, recessionary gaps decrease inflation.
• Inflation shock: a sudden change in the normal behaviour of inflation, unrelated to nations output gap.
• Shock to potential output.

Question 9

Short run aggregate supply (SRAS)

Answer 9

A horizontal line showing the current rate of inflation, determined by past expectations and pricing decisions.

Question 10

Long run aggregate supply (LRAS)

Answer 10

A vertical line showing the economy’s potential output Y*

Question 11

Short run equilibrium in AD-AS

Answer 11

Occurs when:
- Inflation equals the value of inflation determined by past expectations and pricing decisions
- Output equals level of short run equilibrium output that is consistent at this inflation rate.
Graphically occurs:
- At the intersection of the AD curve and SRAS line

Question 12

Long run equilibrium in AD-AS

Answer 12

Occurs when:
- Actual output equals potential output and inflation rate is stable.
Graphically occurs:
- At the intersection of the AD curve, SRAS line and LRAS line.

Question 13

How does the economy reach the long run AD-AS equilibrium (self correcting mechanism)

Answer 13

• In a recessionary gap, firms will reduce prices as they are not selling all the output they are producing. This puts downward pressure on inflation which will decrease SRAS until it reaches the point where AD, SRAS and LRAS intersect - the long run equilibrium.
• In an expansionary gap, firms will increase prices as they are selling more output than they are producing. This puts upward pressure on inflation which will increase SRAS until it reaches the point where AD, SRAS and LRAS intersect - the long run equilibrium.
  This self correcting in the long run is not present in the Keynesian model as the Keynesian model focuses on the short run with no price adjustment.

Question 14

What determines the speed of self correction in the AD-AS model

Answer 14

Speed of the self correction depends on the use of long term contracts and the efficiency and flexibility of labour markets.

Question 15

How are fiscal and monetary policy affected by the speed self correcting

Answer 15

• When self correction is slow, fiscal and monetary policy can help stabilise the economy.
• When self correction is fast, fiscal and monetary policy are ineffective and can destabilise the economy.
• Fiscal and monetary policy are most useful when attempting to eliminate large output gaps.

Question 16

What are the effects of an adverse inflations shock

Answer 16

• Shock increases π and SRAS to π’ and SRAS’
• Short run equilibrium occurs where SRAS and AD intersect.
• Y falls to Y’. Y’ < Y* meaning a recessionary gap but also higher inflation - stagflation.

Question 17

Use of policy after adverse inflation shocks

Answer 17

• If no policy is used, π falls back to the long run equilibrium.
  This can take a long time depending on the speed of self correction so should only be done if the inflation shock was not large. Prioritise inflation over output gap.
• If policy is used, AD shifts to AD’, Y returns to Y* but π is higher than before the output gap.
  If inflation shock was large, policy should be used to prioritise reducing output gap over inflation.
• Decision on whether to use policy or not depends on the size of the inflation shock and the speed of self correction.

Question 18

Effects of a shock to potential to output

Answer 18

• Y* falls to Y*’, LRAS falls to LRAS’
• SRAS increases to SRAS’
• Permanent decrease in output as the long run equilibrium has decreased.