Topic 7: AS-AD Model in the Long Run - Knowledge Summary and Exam Analysis

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University of Toronto Scarborough
Economics for Management Studies
Iris Au

Knowledge Summary: Topic 7: Part A – The AS-AD Model in the Long Run The Effect of a Change in Wages on AS and AD curves • Inflationary or deflationary gap can be eliminated by change in (nominal) wages in the long run • A rise or fall in (nominal) wages will have no effect on AD curve • For AS curve: o When wages rise, production costs increase => firms’ profit decreases -> firms willingness to supply decreases => AS curve shifts to the left o When wages fall, , production costs decrease => firms’ profit increases -> firms willingness to supply increases => AS curve shifts to the right The (Natural) Adjustment Mechanism from the Short Run to the Long Run • There is pressure for wages to change if Y* does not equal tFEin the short run • Case 1: For Deflationary Gap (Y* < Y ) FE o Since Y* < YFE,here is lots of unemployment => pressure for wages to decrease o When wages decrease => AS curve shifts to the right o AE shifts upward due a decrease in P => movement along the AD curve until equilibrium is reached • Case 2: For Inflationary Gap (Y* >FE ) o Since Y* > YFE,here is a shortage of labour => pressure for wages to increase o When wages increase => AS curve shifts to the left o AE shifts downward due an increase in P => movement along the AD curve until equilibrium is reached Note: • Since the natural adjustment mechanism for the AS curve always go back to FE, this indicate that the long-run AS curve is vertical. The position of AD curve is what determines the long-run price level Does the Adjustment Mechanism Actually Work? • Case 1: For Deflationary Gap (Y* < FE) o Wages are sticky downwards because: (meaning it takes a long time for the LR to arrive)  Workers are very reluctant to lower their wages, even if they are out of work – people are not happy to give up what they think they have earned  Firms are not so anxious to replace their workforce in order to cut wages • Case 2: For Inflationary Gap (Y* > YFE o Increase in wages might lead to larger increase in prices  Once people expect wages to increase, they are likely to ask for even higher wages  When wages and prices keep rising, this would shift the AS curve to the left and might be even beyond the full employment level of output, YFE Conclusion • In the short-run, counter-cyclical fiscal policy can be used to bring Y* back toFE • In the long run, counter-cyclical fiscal policy can be used to bring Y* back toFE ; or the economy can bring itself back to Y through the (natural) adjustment mechanism FE Topic 7: Part B – Introduction to Money • Money is defined as anything that is generally accepted as a medium of exchange • Money is the most liquid asset in the economy, meaning that it can easily convert to goods and services • Money must be recognizable, portable, divisible, durable, and hard to counterfeit Functions of Money 1) Medium of exchange: An item that buyers give to sellers when they want to purchase goods and services 2) Unit of account: A way to quote prices 3) Store of value: An alternative for us to hold our wealth Different Measures of Money Motives for Holding Money 1) Transaction motive – we hold money to facilitate our daily purchases/transactions 2) Precautionary motive – we hold money because we are uncertain about when some expenditure will be necessary 3) Speculative motive – we hold money as a way to preserve our wealth Topic 5,6 & 7 – Final Past Paper Answers 2006 Final Q17 – Q21: 17) P o 250, Y o 1620, Y FE= 1620, w o 100 New AD 1 Y = 930 + (125 – 0.5P) + 4/9Y 0.5P = 1055 – 5/9Y P = 2110 – 10/9Y Let AD 1 AS 2110 – 10/9Y = (-110 + 2/9Y)(100/100) 2220 = 12/9Y Y = 1665 SR Therefore, ∆Y = 45 Answer is H 18) P SR= 260 Therefore, ∆P = 10 Answer is N 19) Since SR equilibrium is also equal to LR equilibrium, when the SR equilibrium is restored, it means that Y must go back to Y FETherefore, shift in the AE curve must be 0, even though prices might be adjusted when compared to the initial equilibrium. Answer is A 20) Sub Y FE1620 into AD 1 P = 2110 – (10/9)(1620) P LR= 310 Answer is X 21) Sub Y FEP LRinto AS 310 = [-110 + (2/9)(1620)](w/100
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