Week 7 Lecture 2

Question 1

What conditions are satisfied when the economy is in long-run equilibrium?

Answer 1

• Output = Natural output
• Expected price level = Actual price level
• The AD, SRAS and LRAS curves all intersect at the same point

Question 2

Explain the economic fluctuations that occur when there is a contraction in aggregate demand (AD shifts left)

Answer 2

• When AD shifts left this leads to a demand driven contraction where output falls, unemployment increases and the price level falls
• With time however, the SRAS curve shifts right and output reverts to its natural rate as the price level adjusts downwards

Question 3

Draw a diagram to show the economic fluctuations that occur when there is a contraction in AD

Answer 3

See slide 6 of Week 7 Lecture 2

Question 4

When the price level drops on a AD contraction diagram, what does this show us?

Answer 4

The drop in price from p1 to p2 shows us that actual price level is now less than the expected price level

Question 5

Explain the economic fluctuations that occur when there is a contraction in aggregate supply (AS shifts left)

Answer 5

• When AS shifts left this leads to an aggregate supply driven contraction
• Output falls, the price level increases and stagflation occurs
• With time however SRAS shifts back to the right and output reverts to its natural rate as the price level falls

Question 6

If the AD or AS curve shifts to the right what type of economic fluctuation occurs?

Answer 6

We get aggregate demand driven expansion or an aggregate supply driven expansion (both booms)

Question 7

When SRAS shifts left, how may policymakers react to counter the drop in output?

Answer 7

• The may elect to shift the AD curve right so that output returns more quickly to its natural rate
• The cost of this is higher inflation will occur

Question 8

Draw a diagram to show how policymakers elect to shift AD right to combat AS shifting left

Answer 8

See slide 14 of Week 7 Lecture 2

Question 9

What are the two possible ways in which policymakers can shift the AD curve?

Answer 9

• Monetary policy (Changes in the money supply and/or interest rates)
• Fiscal policy (changes in government spending)

Question 10

Draw a diagram to show how expansive monetary policy increases AD through an increase in the money supply

Answer 10

See slide 16 of Week 7 Lecture 2

Question 11

Explain how changes in the money supply shifts the AD curve

Answer 11

• An increase in the money supply leads to lower interest rates which is expansionary (shifts AD to the right for any given price level)
• A decrease in the money supply leads to higher interest rates which is contractive (shifts AD to the left for any given price level)

Question 12

What effect does fiscal policy have on the AD curve?

Answer 12

Fiscal policy directly shifts the AD curve to the right if the fiscal policy is expansionary and to the left if the fiscal policy is contractionary

Question 13

What does whether a £1 increase in net government spending leads to AD rising by more or less than £1 depend on?

Answer 13

It depends on the relative size of these two opposing effects:
- Multiplier effect (Amplifies the effect on AD of an increase in net expenditure)
- Crowding out effect (Diminishes the effect on AD of an increase in net expenditure)

Question 14

How does the effect does the multiplier effect have on a shift right in AD due to an injection?

Answer 14

The multiplier effect causes a further shift right in AD after the original shift due to the injection

Question 15

What is the spending multiplier?

Answer 15

The spending multiplier refers to a further increase in AD following an injection due to an increase in consumer spending/consumption

Question 16

What does the size of the spending multiplier depend on?

Answer 16

The size of the spending multiplier depends on the marginal propensity to consume (MPC)

Question 17

Define the marginal propensity to consume (MPC)

Answer 17

MPC is the proportion of any extra income that consumers spend on consumption

Question 18

The larger the MPC…

Answer 18

The larger the multiplier

Question 19

Explain the crowding-out effect of an increase in government spending

Answer 19

• When the AD curve shifts right this leads to an increase in income
• This leads to an increase in the money demand
• This increases the interest rate which in turn reduces investment spending and the AD curve shifts back towards the left

Question 20

Draw a diagram showing the crowding-out effect of an increase in government spending

Answer 20

See slide 25 of Week 7 Lecture 2

Question 21

What is active stabilisation policy?

Answer 21

• Active stabilisation policy occurs when authorities use fiscal and monetary policy to stabilise the economy in the face of shocks to the economy
• The objective is to ensure full employment and stable inflation

Question 22

What do Keynesians believe about using policy for stabilisation?

Answer 22

Keynesians believe that the government should actively stimulate aggregate demand in order to maintain production at its full employment level

Question 23

Explain the case against active stabilisation policy

Answer 23

• AD is difficult to control since policy affects the economy with long and variable lags
• Policy must be based on unreliable economic forecasts which leads to mistakes
• Subject to corruption and waste
• Hence it is better to leave the economy alone and let market mechanisms deal with short-run fluctuations

Question 24

What are automatic stabilisers?

Answer 24

Automatic stabilisers are automatic changes in spending that stimulate aggregate demand when the economy goes into a recession

Question 25

Give an example of automatic stabilisers working during a recession

Answer 25

In a recession: - Fewer taxes are collected in a recession - More unemployment benefits are paid out in a recession so AD increases