1
Q
ad-as model
A
- basic assumptions
- > time horizon is longer than in the keynesian model
- > price and output can change over time
- > used to analyse fluctuations
2
Q
aggregate demand
A
- relationship between inflation (pie) and short run equilibrium output (Y)
- downward sloping
3
Q
inflation, rba and ad curve
A
- RBA plays a major role in explaining the AD curve
- Increase inflation -> Increase R -> decrease expenditure -> decrease Y
4
Q
Slope of the AD
A
- Reserve bank reaction function: highr inflation inplies higher inflation rate
- Exports effect: increases in the price of domestic goods sold abroad
- wealth effect: decrease spending when they experience a decrease in their wealth’s purchasing power
- distributional effects: the poorer spend greater percentage of their income than the wealthier
- uncertainty: consumers and firms spend less in an uncertain environment
5
Q
what causes the ad curve to shift?
A
- exogenous changes in C I G NX
- e.g. at a given rate of x, one or more components of PAE decreases
- causes a drop in production and AD1 decreases to AD2
6
Q
shifts of the ad curve - policy reaction function
A
- -upward shift in the policy reaction function indicates the RBA is raising the real interest rate for each level of inflation
7
Q
long run aggregate supply line
A
- LR, the quantity of output supplied depends on the economy’s K and L and technology for turning these inputs into outputs
- does not depend on inflation rate
8
Q
inflation and output gaps
A
- if Y=Y*(Potential), there is no incentive for the firm to increase its price relative to prices of other goods
- inflation rate tend to remain the same
9
Q
Y>Y*
A
- Expansionary output gap
- where sales exceed normal production rates
- firms will increases their prices by more than their costs,
- inflation rate increases
10
Q
- Self correcting economy
A
- ad/as model implies that the economy exhibits a self correcting property
- output gaps can be closed through rising or falling inflation - naturally occuring
- keynesian model does not include a self-correcting mechanism
11
Q
How long is long run
A
- larger the initial output gap, the longer the adjustment time
12
Q
a shift in AD- Weak demand
A
- initially economy is at long run equilibrium
- pessimism waves overtake economy, ad falls
13
Q
insufficient spending and policy responses
A
- adopt fiscal policy to increase G / reduce T and shift the AD curve to the right
- Change monetary policy’ reduce cash rate -> shift right
14
Q
inflation shocks
A
- Inflation increases, SRAS shifts up to SRAS’
- Output falls at short run equilibrium B
- Existence of recessionary gap, inflation begins to drift downward
- Eliminated at A
15
Q
Inflation shocks and RBA
A
- If RBA aggressively shifts the reaction function, AD curve would be shifted to right
- Y* realised faster but at a higher rate of inflation
16
Q
Shocks to potential output
A
- Starting at A
- > a sharp rise in the price of oil could affect the economy’s potential output
- Reduction in the capital stock will shift the LRAS to left
- Reduced capacity to meet demand = expansionary gap
- Higher inflation rate
- > RBA can increase interest rate, pushing AD to left
- Inflation is stable in short run but higher levels of unemployment and smaller output
17
Q
summary
A
- ad/as has 3 components, SRAS, LRAS, Downward sloping AD
- SR.E. = AD intersects SRAS
- LR.E. = AD interesects LRAS
- economy has tendency to correct itself back to its long-run equilibrium
- AD-AS Diagram showcases dilemma facing the RBA; trade off b/w inflation and output
