ECON1102 Final: The AD-AS Model

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17 May 2018

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The AD-AS Model

• The AD-AS model examines how short-run fluctuations in real GDP and the price level occur and how

they affect total output.

The AD/AS Curve v Market Demand/Supply Curves

• The AD curve is built from the demand expenditures side of the whole economy (C+I+G+NX) and

shows AD associated with different price levels.

• Whereas, a market demand curve shows MB/ the willingness-to-pay for a given good at various

prices.

• The AS curve shows how changes in the price level changes the amount producers in aggregate will

offer to the whole economy in the short-run.

• Whereas, a market supply curve shows MC for producers in a particular market.

AD Slope Sign

• Why the AD curve is downward sloping (i.e. the sign of the slope is negative):

1. The wealth effect - a change in the price level affects real wealth and hence consumption.

2. The interest-rate effect - a change in the price level affects real interest rate and hence

investment (primarily).

3. The international-trade effect - a change in the price level affects relative real price of

foreign and domestic goods and also international trade rates and hence net exports.

AD Slope Magnitude

• The AD curve shows the relationship between the price level and the quantity of real GDP demanded,

holding everything else constant.

• Changes in the price level are depicted as movements up or down a stationary aggregate demand curve.

So the relationships of C, I, G and NX to AD given changes in price level are all inverse, i.e. price level

increases reduce one or more of these components and make the sign of the slope negative.

• The strength of the various effects makes the curve shallower or steeper, ceteris paribus (i.e. changes

the magnitude of the slope). Thus, if I is very sensitive to real interest rate changes as affected by the

price level, then the AD curve will be steeper than when I is not very sensitive to such changes.

AD Shifts

• Slopes refer to movements along the curve. But the AD curve may shift when an exogenous shock

occurs.

• Variables that shift AD curve:

1. Changes in gov. policies, eg: taxes, gov. purchases.

2. Changes in expectations of households and firms.

3. Changes in foreign variables in economies outside the domestic economy, eg: relative income

levels between countries.

1) Long-Run Aggregate Supply

• Long-run aggregate supply (LRAS) curve - a curve that shows the relationship in the long-run between

the price level and the quantity of real GDP supplied.

• The LRAS curve shows that, in the long run, increases in the price level do not affect the level of real

GDP. The LRAS curve is a vertical line at potential GDP.

1) Short-Run Aggregate Supply

• The SRAS curve is upward sloping, showing that, in the short-run, firms will produce more in response to

higher prices (money is not neutral in the short-run).

• This is because the price of inputs (i.e. L and K) tend to rise more slowly than the prices of final

products.

• Three major reasons for the upward slope:

1. Money

Illusion

• Refers to the idea that in the short-run people can 'misread' inflation as higher or

lower than it actually is.

• People plan for the future based on their expectations of inflation. If actual inflation

during a period is different than expected, they can have a temporary illusion as to

the real value of wages or prices or interest rates based on a (temporary)

misunderstanding of what inflation actually is.

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Document Summary

The ad-as model examines how short-run fluctuations in real gdp and the price level occur and how they affect total output. The as curve shows how changes in the price level changes the amount producers in aggregate will offer to the whole economy in the short-run: whereas, a market supply curve shows mc for producers in a particular market. The ad curve shows the relationship between the price level and the quantity of real gdp demanded, holding everything else constant. Changes in the price level are depicted as movements up or down a stationary aggregate demand curve. So the relationships of c, i, g and nx to ad given changes in price level are all inverse, i. e. price level increases reduce one or more of these components and make the sign of the slope negative. The strength of the various effects makes the curve shallower or steeper, ceteris paribus (i. e. changes the magnitude of the slope).

Related Questions

In the AD-AS model, stagflation does not persist, because the working of the self-correcting mechanism of the economy _____ the level of output and _____ the price level until the economy eventually returns to a long-run equilibrium state, where actual output _____ potential output.

	decreases; decreases; falls short of
	increases; decreases; equals
	decreases; increases; exceeds
	decreases; increases; equals
	increases; decreases; exceeds

The LRAS curve is drawn as a vertical line at potential output (Y*) to indicate that

	Y* is independent of the price level and that actual output Y > Y* in the long run
	Y* equals actual output (Y) in the long run
	Y* is independent of the price level and that actual output Y = Y* in the long run
	Y* is independent of the price level
	Y* is independent of the price level and that actual output Y < Y* in the long run

Stagflation arises in the context of the AD-AS model when some external factor causes

	the LRAS curve to shift to the right
	the AD curve to shift leftwards
	the SRAS curve to shift downwards
	the SRAS curve to shift upwards
	the AD curve to shift rightwards

If the SRAS curve is positively sloped, then a decrease in the demand for Canadian-made goods in Europe will lead to _____ in the price level, in the short run.

	either an increase or a decrease
	no change
	an increase
	a decrease
	an initial increase, and then a decrease

Which of the following will shift the aggregate demand curve to the right?

	Consumers become pessimistic about the future
	A new technology is developed that will increase profits
	Income taxes are raised
	Foreign economies fall into recession, reducing their demand for domestic exports
	The government reduces purchases to balance the budget

Suppose a stock market crash decreases the stock of household wealth and therefore causes autonomous consumption to fall. Which of the following is the likely result?

	A leftward shift the AD curve
	There will be no movement of the AD curve
	A movement down the AD curve
	A movement up the AD curve
	A rightward of the shift the AD curve

An economy is characterized by the AD equation P = 200 ? 0.02Y, SRAS equation P = 100 and LRAS equation Y* = 5000. In the absence of any change in policy or exogenous shocks, this economy will achieve a long-run price level of

	100
	110
	120
	90
	105

The AD-AS model depicts a self-correcting economy. This means that the price level in the model adjusts automatically in response to a(n) _____ gap, so as to eliminate the _____ gap in the long run, without requiring any help from government policies.

	recessionary; recessionary
	recessionary; expansionary
	expansionary; expansionary
	output; output
	expansionary; recessionary

The aggregate demand curve shows

	the amount of planned aggregate expenditure (and output) at the current price level
	the amount of planned aggregate expenditure (and output) at an average price level
	the amount of planned aggregate expenditure (and output) at a constant price level
	the amount of planned aggregate expenditure (and output) at various price levels
	the amount of planned aggregate expenditure (and output) at last year's price level

Consider an economy initially at long-run equilibrium with output (Y) equal to potential output (Y*). If the SRAS is positively sloped, then a shift to the right of the AD curve will lead to _____ in the price level, in the short run. In the long run, the SRAS curve will shift to the _____ and the equilibrium will be at __________.

	an increase; left; Y = Y*
	a decrease; right; Y > Y*
	an increase; right; Y = Y*
	a decrease; left; Y > Y*
	no change; left; Y = Y*

Part 1

Evaluate whether each of the following statements is true or false. Explain your answer and provide a supporting rationale.

a.The short-run aggregate supply (SAS) curve slopes upward because households spend more as their incomes increase.

b.The long-run aggregate supply curve can never shift.

c.Either a decrease in the nominal money supply by the Federal Reserve, all else held constant or an increase in the price level, all else held constant, will shift the aggregate demand (AD) curve to the left.

d.The Keynesian portion of the short-run aggregate supply (SAS) curve would be relevant during a recessionary situation.

e.Stagflation occurs when the aggregate demand (AD) curve shifts out on the upward sloping portion of the short-run aggregate supply (SAS) curve.

Part 2

Evaluate whether each of the following statements is true or false. Explain your answer and provide a supporting rationale, using graphs to support your answer. You can create graphs by hand and take pictures and upload them with your answers, or you may use Word or Excel, and upload the file created by these software packages.

a.If the real money demand is greater than the real money supply, interest rates must rise to reach equilibrium in the money market as institutions sell bonds to obtain more money.

b.The federal government's control of the money supply, which influences interest rates, is the primary tool that policymakers use to impact the macroeconomy.

c.A decrease in the reserve requirement decreases the money supply because banks have fewer reserves.

d.The real money demand curve shows how households and businesses change their spending in response to changes in the interest rate.

e.Both an increase in the nominal money supply by the Federal Reserve and an increase in the price level will cause the real money supply curve to shift to the right.

yellowseal739

1. Which of the following shifts aggregate demand to the right?
a. Congress reduces purchases of new weapons systems.
b. US exports increase.
c. The price level falls
d. New developments in IT increase the productivity of most manufacturing industries in the US.

2. Suppose the EPA introduces new smog regulation that makes it costlier to produce cars. As a result, aggregate supply falls (primary effect) and firms cut back on production. With less output in the economy available for consumers, consumers bid up the prices of available output. With higher prices, firms choose to produce more (secondary effect).
Which of the following best explains what the net effect on GDP?
a. The two effects should essentially cancel out, with little to no effect on GDP, but the price level clearly rises.
b. It is impossible to say what happens to GDP without being able to compare the magnitudes of the two effects.
c. Real GDP rises as the secondary effect dominates the primary effect.
d. Real GDP falls since the primary effect dominates the secondary effect.

3. A Keynesian economist who observes an output gap would conclude that
a. aggregate demand should be shifted to the right.
b. a policy of deregulation would be better than demand management policy
c. aggregate supply should be shifted to the right
d. All proposed answer options are correct

4. Monetarists believe
a. the Aggregate Supply curve is upward-sloping (but not vertical) over all time frames.
b. the Aggregate Supply curve can be treated as horizontal in the long run (over 10 years
c. the Aggregate Supply curve is vertical only in the very long run (over 20 years).
d. the Aggregate Supply curve can be treated as vertical in the short-to-medium run (1-2 years)

5. Suppose the price of oil increases due to conflict in the Middle East. How will this be illustrated in the AD-AS model?
a. The aggregate demand curve will shift to the left
b. The aggregate supply curve will shift to the left.
c. The aggregate demand curve will shift to the right
d. The aggregate supply curve will shift to the right

6. Assume a Keynesian AS curve. In the short run, when there is a large output gap
a. contractionary demand management policy is likely to be highly inflationary
b. expansionary demand management policy does not cause much inflation.
c. expansionary demand management policy is likely to be highly inflationary
d. the government should use contractionary demand management policy

7. As a result of Bush tax cuts that partially expired in January 2013, the marginal tax rates for some households increased and these households paid higher taxes. Which of the following would be the best description of the tax cut expiration?
a. Rightward shift in AS
b. Rightward shift in AD
c. Leftward shift in AD
d. Leftward shift in AS

8. Suppose that the U.S. government increases income taxes on individuals earning more than $500,000/year and uses the revenue from this tax increase to subsidize the cost of energy for businesses. How will this policy change affect the U.S. economy?
a. The effect on output is ambiguous but price level will decrease for sure
b. The effect on both output and price level is ambiguous.
c. The effect on price level is ambiguous but output will increase for sure
d. The effect on price level is ambiguous but output will decrease for sure

9. If Australia, which imports goods from the United States, went into recession, we would expect that U.S. net exports would
a. rise, making aggregate demand shift right.
b. rise, making aggregate demand shift left
c. fall, making aggregate demand shift left
d. fall, making aggregate demand shift right

10. Suppose that Greece decides to exit the European Union and the Euro Zone, causing a boost in business confidence in European markets. How would you illustrate the primary effect of Greeceâs decision in the AD-AS model for the EU economy?

Note: for this question, assume that Y in the AD-AS model represents output (GDP) of EU member countries without Greece.
a. a shift in the aggregate supply curve to the left and a shift in the aggregate demand curve to the left
b. a shift in the aggregate demand curve to the right
c. a shift in the aggregate demand curve to the left
d. movement along the aggregate demand curve to the left

11. The Austrian school of thought believes that demand management policy should not be used because
a. big government prefers deregulation, which shifts aggregate supply
b. the economy is always at full employment
c. shifting AD to the right is likely to cause deflation
d. big government has a bias towards inflationary policy

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ECON1102 Final: The AD-AS Model

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