Chapter 11 AD/AS Model

What is Say’s Law?

Supply creates it’s own demand; a given value of supply must create an equal value of demand somewhere in the economy

What classification is Say’s Law?

Neoclassical

Describe how recession can happen under Say’s Law

total supply always creates total demand, but even with that, some firms still suffer because a recession means that the economy is shrinking as a whole. if the amount of businesses suffering exceeds the amount of success, recession can still happen

Is Say’s law good for short term or long term? Why?

Say’s law is good for long term because it does not apply well to recessions, which is short term

What is Keynes’ Law

Demand creates its own supply

Describe Keynes’ viewpoint on the Great Depression

He believed that it wasn’t caused by the lack of ability to produce but by lack of demand

What argument about GDP derived from Keynes’ law?

GDP is not determined by total supply, but total demand

Is Keynes’ Law better suited for short term or long term?

Short term because it applies well to recessions when demand drops or when there is so much demand producers can’t keep up

What is aggregate supply?

total quantity of output firms will produce and sell

Why does aggregate supply slope up?

because as average price level of outputs rises, as long as inputs remain fixed, firms have an incentive to produce more for profit

What is the potential GDP line for AS?

how much that economy can produce with full employment and physical capital

What does the far left of AS curve represent?

the economy is employing its existing level of labor, physical capital, and technology available in the market, at the far let this means low levels of output and high unemployment; a small increase in average price level can cause a big increase in supply

Describe what happens when GDP increases

Firms start running into production limits, and price level has less of an effect on production so the curve shifts in smaller increments

What is aggregate demand?

refers to the amount of total spending on domestic good and services in an economy

4 components of demand

Consumption + investment + government spending + exports - imports

Does AD curve slope down or up?

Down; price goes down, GDP goes up

Real Balances Effect

Price level decreases, purchasing power increases, consumption increases, production increases, GDP increases

Interest Rate Effect

Price goes down, demand for borrowing goes down, cost of borrowing goes down, private investments go up, production goes up, GDP goes up

Foreign trade effect

Price level goes down, demand for domestic products goes up, demand for foreign product goes down, domestic product production goes up, GDP goes up

Profit effect

Price goes up, company earnings goes up, production goes up, GDP goes up

Cost effect

GDP goes up, value of input resources goes up, cost of production goes up, price goes up

What is the most important factor that shifts the AS curve and what is its effect?

Productivity growth; higher productivity means a shift to the right, lower shift to the left

SRAS

short run aggregate supply; another name for AS curve

LRAS

long run aggregate supply; another name for potential GDP line

What does an SRAS shift to the right mean?

Greater output and downward pressure on average price level

What does an SRAS shift to the left mean?

Greater input prices which means lower GDP

What does an increase in input prices mean for the economy?

Discourages production which leads to a shift in the left of the AS curve meaning potential recession, higher unemployment, and higher inflation which means higher average price level

What other factors cause a shift in the AS curve

cost of labor, wages, cost of imported goods

What supply shocks can cause a shift to the left

Shock to input goods (ex. early freeze can destroy crops), shock to labor market (ex. pandemic, loss of lots of workers slowing production down)

Why are imports subtracted from AD

Because AD only includes domestic goods, but imports are included in consumption so they must be subtracted to maintain accuracy

Describe the effects a rise in confidence for the economy can have on AD

For individuals, this means more spending, increases consumption. For businesses, this means increasing investment spending

How does tax policy affect AD

Tax cuts will increase consumption while tax increases will diminish it, tax policy can also offer lower rates for businesses increasing their investment spending

A shift to the right in AD = ?

greater GDP and upward pressure on average price level

A shift to the left in AD = ?

lower GDP and lower average price level

How does economic growth affect AD/AS in the long run? short run?

in the long run, productivity promotes economic growth which is represented by a gradual shift to the right in potential GDP and the AS curve as a whole. in the short run, GDP falls and rises when going in and out of recession

What happens in the short run to AD/AS in terms of unemployment?

Cyclical unemployment is related to short run effects on AD and AS. Cyclical unemployment is determined by how close output is to potential GDP. The closer it is, the better

What are the two ways inflationary pressure may arise in AD/AS model

if AD continues to shift right when economy is at or near potential GDP, it will continue pushing the equilibrium into the steep portion of AS curve; if there is a rise input prices, it causes the AS curve to shift left

Why might inflation persist?

If the government continually stimulates AD and keeps pushing the curve when it is already steep, or there is an expected rate of inflation so people plan for that and cause price, wages, and interest rates to all go up annually

Describe the Keynesian zone in the AD/AS model

AD largely determines output, has little effect on average price level; accompanied with recession and high unemployment

Describe the neoclassical zone

AD does not really affect output, but has a large effect on average price level; cyclical unemployment is low, but structural unemployment can still be an issue

describe the intermediate zone

movement in AD affects both output and average price level; shift in AD to the right moves output closer to potential GDP, reducing unemployment but creating a higher average price level. shift to the left does the opposite