AS-AD Model

Question 1

What are the key assumptions of the simple Keynesian/AE model?

Answer 1

• Spending (demand) is the driving force of the economy.- Supply adjusts passively to demand.- Prices are fixed.- Wages are fixed.- The money supply is constant.- Interest rates are fixed.

Question 2

Given Autonomous Consumption (C₀) = R250m, Investment (I) = R150m, and MPS = 0.2, what is the equilibrium level of income?

Answer 2

• MPC = 1 - MPS = 0.8.- AE = (250 + 0.8Y) + 150 = 400 + 0.8Y.- Y = AE → Y = 400 + 0.8Y → 0.2Y = 400 → Y = 2000.

Question 3

What is the multiplier effect, and what determines its value?

Answer 3

• Multiplier shows how an initial change in spending causes a larger change in income.- Determined by MPC.- Formula: k = 1/(1 - MPC) = 1/MPS.

Question 4

Why does the Aggregate Demand (AD) curve slope downward?

Answer 4

• Wealth Effect: Lower P ↑ real wealth → ↑C.- Interest Rate Effect: Lower P ↑ real money supply → ↓ interest rates → ↑I.- Foreign Purchases Effect: Lower P makes exports cheaper → ↑NX.

Question 5

What factors can cause the AD curve to shift right (↑AD)?

Answer 5

• ↑ Consumer Spending: wealth, ↓ taxes, optimism.- ↑ Investment Spending: ↓ real interest rates, ↑ expected profits.- ↑ Government Spending (expansionary fiscal policy).- ↑ Net Exports: depreciation, higher foreign income.

Question 6

Why does the SRAS curve slope upward?

Answer 6

• Sticky Wages: Output ↑ while wages adjust slowly → ↑ profits → ↑ production.- Sticky Prices: Fixed-price firms sell more.- Misperceptions: Firms misinterpret price rises as demand ↑.

Question 7

Using labour market explanation, why does SRAS slope upward?

Answer 7

• ↑ Output → ↑ Employment → ↓ Unemployment.- ↓ Unemployment → ↑ Bargaining Power → ↑ Wages.- ↑ Wages → ↑ Costs → ↑ Prices.- Positive relationship between P and Y.

Question 8

Why is the LRAS curve vertical?

Answer 8

• Long run output = potential output.- Determined by labour, capital, technology.- Prices and wages flexible.- P changes do not affect real GDP.

Question 9

What factors shift AS right (↑AS)?

Answer 9

• ↓ Resource Prices (e.g., wages, capital).- ↑ Productivity (tech improvements).- Favorable legal changes (↓ taxes, ↑ subsidies).

Question 10

What is demand-pull inflation?

Answer 10

• Inflation from ↑AD.- AD shifts right.- Short run: ↑ Output, ↑ Price level.

Question 11

What is cost-push inflation, and its consequence?

Answer 11

• Inflation from ↓AS (e.g., oil shock).- AS shifts left.- Leads to stagflation (↑ inflation + ↓ output + ↑ unemployment).

Question 12

What is the policy dilemma of stagflation?

Answer 12

• Expansionary policy fights unemployment but worsens inflation.- Contractionary policy fights inflation but worsens unemployment.- Hard to fix both simultaneously.

Question 13

Describe the long-run adjustment process after ↑AD.

Answer 13

• AD ↑ → Y ↑ and P ↑.- Workers demand ↑ wages → ↑ costs → SRAS shifts left.- Output returns to potential GDP.- P permanently higher.

Question 14

Why might prices and wages not fall during a recession?

Answer 14

• Wage contracts (long-term).- Morale/productivity reasons.- Minimum wage laws.

Question 15

Difference between a movement along AD vs a shift of AD?

Answer 15

• Movement along AD: caused by ΔP.- Shift of AD: caused by non-price determinants (C, I, G, NX).

Question 16

How does an exchange rate appreciation affect AS?

Answer 16

• Appreciation → cheaper imports.- ↓ Production costs.- AS shifts right.

Question 17

What is the equilibrium condition in the AE model?

Answer 17

• Equilibrium when AE = Y.- Mathematically: Y = AE.

Question 18

What is the wealth effect in AD?

Answer 18

• Lower P ↑ real wealth → ↑C.- Higher P ↓ real wealth → ↓C.

Question 19

What does the LRAS curve represent?

Answer 19

• Potential output / full employment GDP.- Max sustainable GDP given resources & technology.

Question 20

How does ↑ Money Supply (Ms) affect AD?

Answer 20

• ↑Ms → ↓ interest rates → ↑ Investment.- AD shifts right.

Question 21

What is the consequence of ↓AS (e.g., oil shock)?

Answer 21

• AS shifts left.- ↑ Prices + ↓ GDP.- Causes stagflation.

Question 22

In long-run equilibrium, where do AD, SRAS, LRAS intersect?

Answer 22

• At one point.- Economy at potential GDP.- With equilibrium price level.

Question 23

How is AE derived in a simple economy?

Answer 23

• AE = C + I.- C = C₀ + cY.- I = autonomous.- AE = (C₀ + cY) + I.

Question 24

Why does a R50m ↑ in I → R250m ↑ in Y (MPC=0.8)?

Answer 24

• Multiplier = 1/(1-0.8) = 5.- ΔY = k × ΔI = 5 × 50 = R250m.

Question 25

What is the graphical representation of equilibrium in AE?

Answer 25

- Where AE line crosses 45° line.- 45° line shows AE = Y.

Question 26

When deriving AD from AE, what causes a movement along AD?

Answer 26

- A change in price level shifts AE curve.- Different Ps give new Ys.- Mapping them creates downward-sloping AD.

Question 27

What is the interest rate effect, and which AD component does it affect?

Answer 27

- Lower P → ↑ real money supply → ↓ interest rates → ↑I.- Affects Investment (I).

Question 28

How do expectations shift AD?

Answer 28

- Consumers: Expect ↑ income → spend more → AD right.- Firms: Expect ↑ profits → invest more → AD right.

Question 29

Difference between Δ quantity of GDP supplied vs ΔAS?

Answer 29

- Δ Quantity Supplied: movement along SRAS (caused by ΔP).- ΔAS: shift of SRAS (caused by costs, productivity, resources).

Question 30

Real-world example of LRAS being vertical due to resource limits?

Answer 30

- Singapore: limited land caps output.- SA: agriculture limited by land availability.

Question 31

Immediate effect of positive AD shock (short run)?

Answer 31

- Output ↑ → employment ↑, unemployment ↓.- Prices ↑ (inflation).

Question 32

What is an inflationary gap in AS-AD?

Answer 32

- When SR equilibrium GDP > potential GDP.- Overheated economy.

Question 33

Why does rising P reduce multiplier in long run?

Answer 33

- Short run: k assumes fixed prices.- Rising P erodes real income → weakens spending rounds.- Long run: SRAS shifts left → multiplier effect on Y = 0.

Question 34

What is a negative output gap?

Answer 34

- SR equilibrium GDP < potential GDP.- Indicates recession, unused resources, unemployment.

Question 35

How does technology improvement affect AS?

Answer 35

- ↑ Productivity.- ↓ Average costs.- AS shifts right.

Question 36

What is money neutrality in LRAS context?

Answer 36

- In LR, ↑ Money Supply → only ↑ Prices.- No effect on real GDP or unemployment.- Example: Zimbabwe hyperinflation.