AS-AD Model

Question 1

What are the key assumptions of the simple Keynesian (AE) model?

Answer 1

• Prices are fixed.
• Wages are fixed.
• Interest rates are fixed.
• The money supply is constant.
• Supply adjusts passively to demand.

Question 2

What is the equilibrium condition in the Aggregate Expenditure (AE) model?

Answer 2

• Aggregate Expenditure (AE) equals Real Output/Income (Y). (AE = Y)

Question 3

What is the Keynesian multiplier and what does its value depend on?

Answer 3

• It describes how an initial change in spending leads to a larger change in total income.
• The multiplier (k) = 1 / (1 - MPC) or 1 / MPS.
• It depends on the Marginal Propensity to Consume (MPC).

Question 4

What are the three reasons the Aggregate Demand (AD) curve slopes downward?

Answer 4

• Wealth Effect: Lower prices increase wealth, stimulating consumption (C).
• Interest Rate Effect: Lower prices lower interest rates, stimulating investment (I).
• International Trade Effect: Lower prices boost net exports (NX).

Question 5

What factors can cause the AD curve to shift to the right?

Answer 5

• ↑ Consumer Confidence/Wealth.
• ↓ Taxes (T) or ↑ Government Spending (G).
• ↓ Interest Rates.
• Depreciation of the domestic currency.
• ↑ Foreign income.

Question 6

Why does the Short-Run Aggregate Supply (SRAS) curve slope upward?

Answer 6

• Sticky Wages/Prices: If output prices rise while costs are fixed, profits rise, encouraging production.
• Misperceptions: Firms mistake general price increases for increased demand for their product.
• Labour Market Dynamics: Higher output lowers unemployment, raises wages and costs, forcing price increases.

Question 7

Why is the Long-Run Aggregate Supply (LRAS) curve vertical?

Answer 7

• In the long run, output is determined by the economy’s potential output (full employment of resources).
• Prices and wages are fully flexible, so price level changes do not affect real GDP.

Question 8

What factors cause the AS curve to shift to the right?

Answer 8

• ↓ Input/resource prices (e.g., lower oil prices).
• ↑ Productivity (e.g., better technology).
• ↓ Business taxes or ↑ Subsidies.
• Beneficial legal-institutional changes.

Question 9

What is ‘demand-pull’ inflation?

Answer 9

• Inflation caused by an increase in Aggregate Demand (AD shifting right).
• It results in higher prices and, in the short run, higher output.

Question 10

What is ‘cost-push’ inflation?

Answer 10

• Inflation caused by a decrease in Short-Run Aggregate Supply (SRAS shifting left) due to rising costs.
• It results in higher prices and lower output (stagflation).

Question 11

What is the long-run adjustment process following an increase in AD?

Answer 11

• AD increases, raising output and prices.
• Workers demand higher wages due to higher costs of living.
• Higher wages shift the SRAS curve leftward.
• Output returns to potential GDP (LRAS) at a higher price level.

Question 12

Why might prices and wages be ‘sticky’ downwards in a recession?

Answer 12

• Long-term wage contracts.
• Firms fear wage cuts will harm worker morale and productivity.
• Minimum wage laws.
• Menu costs of changing prices.

Question 13

What is the policy dilemma during a period of stagflation?

Answer 13

• Expansionary policy (↑AD) reduces unemployment but worsens inflation.
• Contractionary policy (↓AD) reduces inflation but worsens unemployment.

Question 14

How is the AD curve derived from the AE model?

Answer 14

• By changing the price level and observing the resulting change in equilibrium real GDP.
• Plotting these different price-level/GDP combinations creates the downward-sloping AD curve.

Question 15

What is the ‘wealth effect’ in the context of the AD curve?

Answer 15

• As the price level falls, the real value/purchasing power of households’ financial assets increases.
• This makes people feel wealthier, encouraging them to increase consumption spending (C).

Question 16

What is the ‘misperceptions’ argument for why the SRAS curve slopes upward?

Answer 16

Producers may misinterpret a general increase in the price level as an increase in the demand specifically for their own product, leading them to increase their output.

Question 17

How does the ‘wealth effect’ (or ‘real balances effect’) contribute to the downward slope of the AD curve?

Answer 17

A lower price level increases the purchasing power (real value) of money holdings and other financial assets, making consumers feel wealthier and thus stimulating consumption spending (C).

Question 18

What is ‘potential GDP’ or ‘full-employment output’?

Answer 18

The level of real GDP an economy can produce when it is fully employing all of its available resources (labour, capital, land, etc.). This is where the LRAS curve is vertical.

Question 19

What is an ‘inflationary gap’ in the AS-AD model?

Answer 19

The situation where the short-run equilibrium level of real GDP exceeds the potential GDP (i.e., it is to the right of the LRAS curve).

Question 20

What is a ‘negative output gap’ (or ‘recessionary gap’)?

Answer 20

The situation where the short-run equilibrium level of real GDP is below the potential GDP (i.e., it is to the left of the LRAS curve).

Question 21

In the long-run adjustment process, what causes the SRAS curve to shift left after an initial increase in AD?

Answer 21

Workers, facing a higher cost of living due to the initial price increase, demand and receive higher nominal wages. This increases production costs for firms, causing them to supply less at every price level, shifting the SRAS curve leftward.

Question 22

What is the key reason presented for why prices and wages may be ‘sticky downwards’?

Answer 22

Firm Reluctance: Firms fear that cutting wages will harm worker morale and productivity, which could end up increasing their costs per unit of output.

Question 23

What is the primary policy dilemma when an economy experiences stagflation (a leftward shift of SRAS)?

Answer 23

• Expansionary policies (to fight unemployment) will worsen inflation.
• Contractionary policies (to fight inflation) will worsen unemployment.

Question 24

According to the model, what is the ultimate cause of the business cycle?

Answer 24

Fluctuations in Aggregate Demand (AD) and Short-Run Aggregate Supply (SRAS), while the money wage rate does not adjust quickly enough to keep real GDP constantly at potential GDP.

Question 25

How does a depreciation of the domestic currency affect the AS curve?

Answer 25

It makes imported resources (e.g., oil, machinery) more expensive in domestic currency, increasing production costs and causing the SRAS curve to shift to the left.