econ1102 chapter 8

macroeconomics 1 - aggregate supply and demand

In the AD-AS model, what is the key channel through which monetary policy affects real GDP?

Changes in the real interest rate affect household consumption and planned investment, which are both components of PAE.

How does a higher real interest rate (r) affect household saving and consumption?

It increases saving and decreases consumption, since saving is positively related to r and consumption is negatively related to r.

What does the term '-ar' represent in the generalised consumption function C = C0 + c(Y-T) - ar?

The negative effect of the real interest rate on consumption, where a > 0 measures consumption's sensitivity to r.

What does the term '-βr' represent in the generalised planned investment function Ip = I0 - βr?

The negative effect of the real interest rate on planned investment, where β > 0 measures investment's sensitivity to r, via the user cost of capital.

Why does a rise in the real interest rate reduce planned investment?

It raises the user cost of capital, making fewer investment projects profitable.

What does the AD curve plot on its two axes?

The inflation rate on one axis and real GDP/output on the other.

Why is the AD curve downward sloping?

Because the central bank's policy reaction function raises the real interest rate as inflation rises, and a higher real interest rate reduces consumption and planned investment, lowering equilibrium GDP.

What happens to the AD curve if the central bank's inflation sensitivity, or the interest sensitivities of consumption and investment, are all zero?

The AD curve becomes vertical.

Besides the interest rate channel, how does higher inflation reduce household consumption through wealth effects?

Higher inflation reduces the real value of cash holdings, making households feel poorer and spend less.

How does unexpected inflation volatility reduce economic activity through precautionary behaviour?

It increases uncertainty, which increases precautionary saving and lowers economic activity.

How does rising domestic inflation reduce net exports through the international competitiveness channel?

If domestic inflation outpaces exchange rate adjustment, local goods become relatively more expensive, reducing exports and increasing imports.

What causes the AD curve to shift outward (right)?

An exogenous increase in consumption, planned investment, exports, expansionary fiscal policy, or expansionary discretionary monetary policy (a decrease in r0).

What causes the AD curve to shift inward (left)?

Contractionary fiscal policy, or discretionary monetary policy involving an increase in r0.

Why can't the AD curve alone determine both the inflation rate and output level?

Because it's one relationship between two unknowns — a second curve, aggregate supply, is needed to pin down the equilibrium.

What three factors influence how much businesses raise their prices, according to the AS model?

Their expectation of inflation, economy-wide changes in production costs, and the size of the output gap.

What does the AS curve plot on its two axes?

The inflation rate and the output gap (or real GDP), similar to the AD curve.

What condition holds if there's a zero output gap and no shocks to inflation?

Actual inflation equals expected inflation.

What is the difference between adaptive and rational expectations of inflation?

Adaptive expectations assume people base forecasts on past inflation; rational expectations assume forecasts incorporate all available information, subject only to an unpredictable random error.

What is the simplest form of adaptive expectations used for the AS curve?

Expected inflation equals actual inflation from the previous period.

With simple adaptive expectations and no shocks or output gap, what does the AS curve predict about inflation over time?

That inflation stays constant, equal to the previous period's rate.

In the AD-AS model with a simple AS curve, does an exogenous shift in AD change the inflation rate or the output level?

Only the output level — the inflation rate stays unchanged.

What is an 'inflation shock' added to the AS equation?

A temporary, exogenous shock that shifts the AS curve up or down along the inflation axis.

What are some example causes of an unfavourable inflation shock?

Changes in indirect tax rates, energy price fluctuations, or large exchange rate movements.

Does an unfavourable inflation shock shift the AS curve up or down?

Up — it's associated with higher inflation at every level of output.

Why do temporary inflation shocks produce a permanent shift in the level of inflation under adaptive expectations?

Because expectations are based on the previous period's actual inflation, so the shock's effect carries forward into future periods.

What happens to the AS curve if there's a short-run expansionary output gap?

Businesses raise prices faster than current inflation, shifting the AS curve up.

What happens to the AS curve if there's a short-run contractionary output gap?

Businesses raise prices more slowly, shifting the AS curve down.

What characterises the long-run equilibrium in the AD-AS model?

Real GDP equals potential output, and the inflation rate is constant over time.

Following a permanent favourable AD shock, what happens to output and inflation in the short run vs. the long run?

In the short run, output rises above potential with no immediate inflation change; in the long run, output returns to potential but inflation rises permanently.

Following a temporary unfavourable AS shock, what happens to output and inflation in the long run once the economy self-corrects?

Output and inflation both return to their original long-run levels, as the AS curve gradually shifts back once the gap disappears.

Does the AD-AS model suggest the economy is self-correcting in the long run?

Yes, but the adjustment process happens very slowly, which is why policy is used to speed it up.

What discretionary policy options exist to counter an adverse (leftward) AD shock?

Reducing r0 through monetary policy, or increasing government spending / cutting taxes through fiscal policy.

What is 'accommodating' an adverse AS shock?

Using expansionary monetary/fiscal policy to eliminate the resulting output gap, at the cost of a permanently higher long-run inflation rate.

What is the alternative to accommodating an adverse AS shock, and what's the trade-off?

Doing nothing and letting the economy return to potential naturally — this avoids permanently higher inflation but means enduring a longer contractionary gap in the short run.

How can a credible inflation target change the way private-sector expectations are formed?

Instead of basing expectations adaptively on past inflation, the private sector can anchor expectations directly to the announced target.

What is a key benefit of anchored inflation expectations following an AS shock?

Inflation tends to return to target more quickly than under adaptive expectations, even without policy accommodation.

What happens to potential output and the AS curve following a negative shock to productivity or innovation?

Potential output shifts left, creating an expansionary gap that forces businesses to raise prices, shifting the AS curve up until it reaches the new, lower potential output.

What is the long-run outcome of a permanent negative shock to potential output, if not addressed with discretionary policy?

Permanently lower production and permanently higher inflation.