Macroeconomics

Lecture Notes 2

Topic 2: Classical Models of the Macroeconomy

Aggregate Demand

Definition of Aggregate Demand- This is the total level of spending on final goods and services in an
economy at a given time.

Definition of Aggregate Demand Curve- The AD curve represents the total quantity of all goods and services
demanded in an economy at different price levels.

Features of the AD Curve:

 The vertical axis represents the price level of

all final goods and services. The aggregate price level is measured by either the GDP Deflator or the
Consumer Price Index (CPI). Note that the GDP deflator and the CPI are price indices.
 The horizontal axis measures the real quantity of goods and services purchased as measured by real
GDP.
 A change in the price level indicates that many prices are changing including the wages paid to
workers.

When the price level is high, aggregate demand is low; when the price level is low, aggregate demand
is high.

There are four major components of aggregate demand.

The equation for aggregate demand, AD = C + I + G + X-M

AD can also be referred to as the total spending in the economy. That is it represents:

 C- CONSUMER SPENDING, this is the total amount that households will spend on goods and
services in the economy. Households spend money on clothes, food, cars, vacation etc.

 I-INVESTMENT SPENDING, this represents the total amount businesses spend on purchasing new
capital equipment in order to increase output.

 G-GOVERNMENT SPENDING, this is the total amount that the government spends in the economy.
The government expenditures include payment for wages, financing infrastructure projects, purchase of
stationary for schools and public offices etc.

 X-M or NX- NET EXPORT SPENDING, In other words, net exports is the amount by which foreign
spending on a home country's goods and services exceeds the home country's spending on foreign
goods and services. It can be negative or positive. If the next exporting figure is positive it means that
export is greater than imports, if the figure is negative it means that the level of imports exceeds export.

Why does the aggregate demand curve slope downwards?

The most noticeable feature of the aggregate demand curve is that it is downward sloping. There are three
basic reasons for the downward sloping aggregate demand curve. These are:

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 1. real money balance effect
2. the intertemporal substitution effect
3. international substitution effect

Real Money Balance Effect

This is because for a given amount of money, a lower price level provides more purchasing power per unit of
currency. When the price level falls, consumers are wealthier, a condition which induces more consumer
spending. Thus, a drop in the price level induces consumers to spend more, thereby increasing the aggregate
demand.

Inter-temporal Substitution Effect

This is the change in the quantity of real GDP demanded resulting from a change in the relative price of a good
or service now or in the future. If you can buy something in the future for less than the sum of today’s price and
earn interest by delaying your purchase then it might be proven to do so.

International Substitution Effect

This is the change in the quantity of real GDP demanded resulting from a change in the relative price of
domestic goods and services and foreign goods and services.

Determinants of Aggregate Demand

The determinants of demand are:

1. Consumption
2. Investment
3. Government spending
4. Net Export

However we must understand that the above variables are affected by intermediate variables such as
taxes, interest rates, exchange rate, business confidence, consumer confidence, national income.

Intermediate Variables are:

1. Taxes

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2. Interest Rates

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3. Exchange Rate

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4. National Income

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5. Consumer Confidence

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6. Business Confidence

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Leftward shifting of the AD curve

The Aggregate Demand Curve will shift to the right if there is a:

 Decrease in the level of direct and indirect taxes which

increase consumer spending
 Fall in the level of interest rates which discourage
savings and increase consumption spending
 Increase in the level of national income as a result of
economic growth or possible lower direct taxes
 Increase in consumer confidence in the economy which
encourage spending
 Increased business confidence which affects investment spending by firms
 A depreciation of the exchange rate against foreign currency which decrease import spending
thus positively impacting net export spending.

Rightward shifting of the AD curve

The Aggregate Demand Curve will shift to the left if there is a:

 Increase in the level of direct and indirect taxes which decrease consumer spending
 Rise in the level of interest rates which encourage savings and reduce consumption spending
 Decrease in the level of national income as a result of economic contractions
 Lack of consumer confidence in the economy which deters spending
 Lack of business confidence which affects investment spending by firms
 An appreciation of the exchange rate against foreign currency which increase import spending
thus negatively impacting net export spending.

Aggregate Supply

Aggregate Supply is the total amount of goods and services that an economy produces over a period
of time.
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The aggregate supply curve shows the relationship between the price level and output.

Under the classical theory, it posits that the aggregate supply curve is made up of the SRAS and LRAS.

Two types of Aggregate supply curve:

1. Short Run Aggregate Supply (SRAS)

2. Long Run Aggregate Supply (LRAS)

Short Run Aggregate Supply Curve

The short run aggregate supply curve is upward sloping. The upward sloping nature of the curve shows that
there exists a positive relationship between the price level and the level of output the economy produces.

Understanding the upward sloping nature of the

aggregate supply curve is not an easy task.

There are TWO major models that explain why the short-term aggregate supply curve slopes upward.

They are:

1. The sticky-wage model.

2. The worker-misperception model.

Sticky-Wage Model

The sticky-wage model of the upward sloping short run aggregate supply curve is based on the labor market.

In many industries, short run wages are set by contracts. Workers are paid based on decisions made by
management or unions or both.

When there are any changes in the economy such higher prices wages will not increase immediately. It takes
time. This means that wages are sticky.

Given that wages are sticky, an increase in the price level means that firms can sell at higher prices with their
wage bill remaining the same. When there is an increase in the price level and the prices of nominal wages
remains the same, the cost labor becomes relatively cheaper. This provides an opportunity to hire more
workers and produce more to make a larger profit.

Thus, when the price level rises, output increases due to the sticky wage model.

Note: Nominal Wage is the dollar amount paid to a worker while real wage is wage adjusted for
inflation.

Worker-Misperception Model

The worker-misperception model of the upward sloping short- run aggregate supply curve is again based on
the labor market. This time, unlike in the sticky-wage model, wages are free to move as the economy changes.
The amount of work that an employee is willing to supply is based on the expected real wage. That is, workers
know how many dollars they are being paid, the nominal wage, but workers can only guess at how much
goods and services they can purchase with this wage, the real wage. In general, the higher the real wage, the
more work that workers are willing to supply.

Now let's say that the price level increases. Because we assume that firms have more information than
workers do, firms will give workers a raise so that their nominal wage increases with the price level. But since
the workers do not realize that the price level increased, they will believe that their real wage increased, not
just their nominal wage. At a higher real wage, workers are induced to work more. When workers work more,
output increases. Thus, when the price level increases, output also increases because of worker-
misperception.

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Let's summarize the chain of events that leads from an increase in the price level to an increase in output in
the worker-misperception model. When the price level rises, firms increase nominal wages. When nominal
wages increase, workers--due to misperceptions--believe that real wages also increase. When workers believe
that real wages increase, workers provide more labor. When workers provide more labor, output increases.

Factors that can shift the SRAS curve

1. Input Prices

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2. Advancement in technology

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3. Business Confidence

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4. Taxes

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5. Subsidies

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Rightward shift of SRAS Curve

The SRAS curve will shift to the right if there is a:

 Fall in input prices such as wages, raw material cost etc.

 Improve in the level of technology which improves productivity and efficiency
 Lowering of business taxes which gives firms more leverage to invest and expand output
 Increase in business confidence which increase the level of investment

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  Increase in the level of government subsidies which lowers production costs and increase
output.

Leftward shift of SRAS Curve

The SRAS curve will shift to the left if there is a:

 Rise in input prices such as wages, raw material cost etc.

 Lack of or inefficient use of technology
 Increase in business taxes which gives firms less leverage to invest and expand output
 Decrease in business confidence which lowers the likelihood of investment
 Decrease in the level of government subsidies which leads to higher production costs and
lower output.

The Long Run Aggregate Supply Curve

The Long run aggregate supply curve shows no relationship between the price level and the level of output in
the economy.

The LRAS curve is vertical. It shows the level of output the economy can produced when all its productive
resources and existing technology are fully employed.

Unlike the SRAS where there exist a relationship between the price level and output, the vertical shape of
LRAS shows no relationship. Any increase in the price level will result in NO increase in the level of output as
the economy, in its current capacity, has reach its limit.

In the SRAS, output increases because output prices lag behind input prices providing firms the opportunity to
produce more. In the LRAS, input prices ‘catches up’ with output prices. Therefore firms output remains
constant.

Factors that can shift the LRAS

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  Productivity
 Labour Supply
 Capital Stock

INTERACTION OF THE SRAS, LRAS AND AD- PRICE DETERMINATION

The effect of an increase in AD.

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The effect of a decrease in AD.

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THE MARKET FOR LOANABLE FUNDS- INTEREST RATE DETERMINATION

In economics, the loanable funds doctrine is a theory of the market interest rate. According to this approach, the
interest rate is determined by the demand for and supply of loanable funds. The term loanable funds includes all
forms of credit, such as loans, bonds, or savings deposits.

The demand for loanable funds in the investment curve as it represents the amount of money being
borrowed to finance investment spending by firms and households

The supply of loanable funds is the saving curve as it represents the amount of money being supplied
to the banks.

It is therefore the interaction of savings and investment that determines the market equilibrium.

Question: How will equilibrium interest rates be restored if the market interest is above or below its
equilibrium level?

UNEMPLOYMENT IN THE CLASSICAL MODEL

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In the classical model, unemployment does not exist. The only type of unemployment that exists in the classical model is
that of voluntary unemployment.

In the classical model, due to the flexibility of wages, the demand for labour will always be equal to the supply of labour.
There exist no excess demand or supply of labour. Anyone without work in the classical model, chose to be unemployed
because they are not willing to work at the current wage rate given by the labour market.

Analysis

The diagram above represents the labour market. The demand curve shows the firms demand for labour, there
is an inverse relationship. When the wage is high, firms demand less worker vice versa. The supply curve
shows the supply of labour by households, there is a positive relationship between the supply of labour and the
wage rate. As wage rates rise, more persons are willing to supply labour services.

MCW, market clearing wage. This is where there is equilibrium in the labour market- no unemployment.
However if wages are raised above MCW, that is at RW- real wage, then the result is excess supply of labour
in the market.

As wages increase to RW, firms will cut back on labour however households will supply more. This then
creates disequilibrium in the market. Real Wage unemployment is a form of disequilibrium unemployment.

In conclusion the classicalists posits that unemployment is always zero as the labour market will always clear.
Anyone found unemployed at this stage are unemployed because they chose not to work at this market
clearing wage.

ADDITIONAL READINGS FOR ASSESSMENT- MUST READ!!

Recessionary and Inflationary Gaps and Long-Run Macroeconomic Equilibrium

Learning Objectives

1. Explain and illustrate graphically recessionary and inflationary gaps and relate these gaps to what is
happening in the labor market.
2. Identify the various policy choices available when an economy experiences an inflationary or
recessionary gap and discuss some of the pros and cons that make these choices controversial.

The intersection of the economy’s aggregate demand and short-run aggregate supply curves determines
equilibrium real GDP and price level in the short run. The intersection of aggregate demand and long-run
aggregate supply determines its long-run equilibrium. In this section we will examine the process through
which an economy moves from equilibrium in the short run to equilibrium in the long run.

The long run puts a nation’s macroeconomic house in order: only frictional and structural unemployment
remain, and the price level is stabilized. In the short run, stickiness of nominal wages and other prices can
prevent the economy from achieving its potential output. Actual output may exceed or fall short of potential
output. In such a situation the economy operates with a gap. When output is above potential, employment is
above the natural level of employment. When output is below potential, employment is below the natural level.

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Recessionary and Inflationary Gaps

At any time, real GDP and the price level are determined by the intersection of the aggregate demand and
short-run aggregate supply curves. If employment is below the natural level of employment, real GDP will be
below potential. The aggregate demand and short-run aggregate supply curves will intersect to the left of the
long-run aggregate supply curve.

Suppose an economy’s natural level of employment is Le, shown in Panel (a) of Figure 7.13, “A Recessionary
Gap”. This level of employment is achieved at a real wage of ωe. Suppose, however, that the initial real wage
ω1 exceeds this equilibrium value. Employment at L1 falls short of the natural level. A lower level of
employment produces a lower level of output; the aggregate demand and short-run aggregate supply curves,
AD and SRAS, intersect to the left of the long-run aggregate supply curve LRAS in Panel (b). The gap between
the level of real GDP and potential output, when real GDP is less than potential, is called a recessionary gap.

Figure 7.13. A Recessionary Gap

If employment is below the natural level, as shown in Panel (a), then output must be below potential. Panel (b)
shows the recessionary gap YP − Y1, which occurs when the aggregate demand curve AD and the short-run
aggregate supply curve SRAS intersect to the left of the long-run aggregate supply curve LRAS.

Just as employment can fall short of its natural level, it can also exceed it. If employment is greater than its
natural level, real GDP will also be greater than its potential level. Figure 7.14, “An Inflationary Gap” shows an
economy with a natural level of employment of Le in Panel (a) and potential output of YP in Panel (b). If the real
wage ω1 is less than the equilibrium real wage ωe, then employment L1 will exceed the natural level. As a
result, real GDP, Y1, exceeds potential. The gap between the level of real GDP and potential output, when real
GDP is greater than potential, is called an inflationary gap. In Panel (b), the inflationary gap equals Y1 − YP.

Figure 7.14. An Inflationary Gap

Panel (a) shows that if employment is above the natural level, then output must be above potential. The
inflationary gap, shown in Panel (b), equals Y1 − YP. The aggregate demand curve AD and the short-run
aggregate supply curve SRAS intersect to the right of the long-run aggregate supply curve LRAS.

Restoring Long-Run Macroeconomic Equilibrium

We have already seen that the aggregate demand curve shifts in response to a change in consumption,
investment, government purchases, or net exports. The short-run aggregate supply curve shifts in response to
changes in the prices of factors of production, the quantities of factors of production available, or technology.
Now we will see how the economy responds to a shift in aggregate demand or short-run aggregate supply
using two examples presented earlier: a change in government purchases and a change in health-care costs.
By returning to these examples, we will be able to distinguish the long-run response from the short-run
response.

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A Shift in Aggregate Demand: An Increase in Government Purchases

Suppose an economy is initially in equilibrium at potential output YP as in Figure 7.15, “Long-Run Adjustment
to an Inflationary Gap”. Because the economy is operating at its potential, the labor market must be in
equilibrium; the quantities of labor demanded and supplied are equal.

Figure 7.15. Long-Run Adjustment to an Inflationary Gap

An increase in aggregate demand to AD2 boosts real GDP to Y2 and the price level to P2, creating an
inflationary gap of Y2 − YP. In the long run, as price and nominal wages increase, the short-run aggregate
supply curve moves to SRAS2. Real GDP returns to potential.

Now suppose aggregate demand increases because one or more of its components (consumption, investment,
government purchases, and net exports) has increased at each price level. For example, suppose government
purchases increase. The aggregate demand curve shifts from AD1 to AD2 in Figure 7.15, “Long-Run
Adjustment to an Inflationary Gap”. That will increase real GDP to Y2 and force the price level up to P2 in the
short run. The higher price level, combined with a fixed nominal wage, results in a lower real wage. Firms
employ more workers to supply the increased output.

The economy’s new production level Y2 exceeds potential output. Employment exceeds its natural level. The
economy with output of Y2 and price level of P2 is only in short-run equilibrium; there is an inflationary gap
equal to the difference between Y2 and YP. Because real GDP is above potential, there will be pressure on
prices to rise further.

Ultimately, the nominal wage will rise as workers seek to restore their lost purchasing power. As the nominal
wage rises, the short-run aggregate supply curve will begin shifting to the left. It will continue to shift as long as
the nominal wage rises, and the nominal wage will rise as long as there is an inflationary gap. These shifts in
short-run aggregate supply, however, will reduce real GDP and thus begin to close this gap. When the short-
run aggregate supply curve reaches SRAS2, the economy will have returned to its potential output, and
employment will have returned to its natural level. These adjustments will close the inflationary gap.

A Shift in Short-Run Aggregate Supply: An Increase in the Cost of Health Care

Again suppose, with an aggregate demand curve at AD1 and a short-run aggregate supply at SRAS1, an
economy is initially in equilibrium at its potential output YP, at a price level of P1, as shown in Figure 7.16,
“Long-Run Adjustment to a Recessionary Gap”. Now suppose that the short-run aggregate supply curve shifts
owing to a rise in the cost of health care. As we explained earlier, because health insurance premiums are paid
primarily by firms for their workers, an increase in premiums raises the cost of production and causes a
reduction in the short-run aggregate supply curve from SRAS1 to SRAS2.

Figure 7.16. Long-Run Adjustment to a Recessionary Gap

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A decrease in aggregate supply from SRAS1 to SRAS2 reduces real GDP to Y2 and raises the price level to P2,
creating a recessionary gap of YP − Y2. In the long run, as prices and nominal wages decrease, the short-run
aggregate supply curve moves back to SRAS1 and real GDP returns to potential.

As a result, the price level rises to P2 and real GDP falls to Y2. The economy now has a recessionary gap
equal to the difference between YP and Y2. Notice that this situation is particularly disagreeable, because both
unemployment and the price level rose.

With real GDP below potential, though, there will eventually be pressure on the price level to fall. Increased
unemployment also puts pressure on nominal wages to fall. In the long run, the short-run aggregate supply
curve shifts back to SRAS1. In this case, real GDP returns to potential at YP, the price level falls back to P1, and
employment returns to its natural level. These adjustments will close the recessionary gap.

How sticky prices and nominal wages are will determine the time it takes for the economy to return to potential.
People often expect the government or the central bank to respond in some way to try to close gaps. This
issue is addressed next.

Gaps and Public Policy

If the economy faces a gap, how do we get from that situation to potential output?

Gaps present us with two alternatives. First, we can do nothing. In the long run, real wages will adjust to the
equilibrium level, employment will move to its natural level, and real GDP will move to its potential. Second, we
can do something. Faced with a recessionary or an inflationary gap, policy makers can undertake policies
aimed at shifting the aggregate demand or short-run aggregate supply curves in a way that moves the
economy to its potential. A policy choice to take no action to try to close a recessionary or an inflationary gap,
but to allow the economy to adjust on its own to its potential output, is a nonintervention policy. A policy in
which the government or central bank acts to move the economy to its potential output is called a stabilization
policy.

Nonintervention or Expansionary Policy?

Figure 7.17, “Alternatives in Closing a Recessionary Gap” illustrates the alternatives for closing a recessionary
gap. In both panels, the economy starts with a real GDP of Y1 and a price level of P1. There is a recessionary
gap equal to YP − Y1. In Panel (a), the economy closes the gap through a process of self-correction. Real and
nominal wages will fall as long as employment remains below the natural level. Lower nominal wages shift the
short-run aggregate supply curve. The process is a gradual one, however, given the stickiness of nominal
wages, but after a series of shifts in the short-run aggregate supply curve, the economy moves toward
equilibrium at a price level of P2 and its potential output of YP.

Figure 7.17. Alternatives in Closing a Recessionary Gap

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Panel (a) illustrates a gradual closing of a recessionary gap. Under a nonintervention policy, short-run
aggregate supply shifts from SRAS1 to SRAS2. Panel (b) shows the effects of expansionary policy acting on
aggregate demand to close the gap.

Panel (b) illustrates the stabilization alternative. Faced with an economy operating below its potential, public
officials act to stimulate aggregate demand. For example, the government can increase government purchases
of goods and services or cut taxes. Tax cuts leave people with more after-tax income to spend, boost their
consumption, and increase aggregate demand. As AD1 shifts to AD2 in Panel (b) of Figure 7.17, “Alternatives
in Closing a Recessionary Gap”, the economy achieves output of YP, but at a higher price level, P3. A
stabilization policy designed to increase real GDP is known as an expansionary policy.

Nonintervention or Contractionary Policy?

Figure 7.18, “Alternatives in Closing an Inflationary Gap” illustrates the alternatives for closing an inflationary
gap. Employment in an economy with an inflationary gap exceeds its natural level—the quantity of labor
demanded exceeds the long-run supply of labor. A nonintervention policy would rely on nominal wages to rise
in response to the shortage of labor. As nominal wages rise, the short-run aggregate supply curve begins to
shift, as shown in Panel (a), bringing the economy to its potential output when it reaches SRAS2 and P2.

Figure 7.18. Alternatives in Closing an Inflationary Gap

Panel (a) illustrates a gradual closing of an inflationary gap. Under a nonintervention policy, short-run
aggregate supply shifts from SRAS1 to SRAS2. Panel (b) shows the effects of contractionary policy to reduce
aggregate demand from AD1 to AD2 in order to close the gap.

A stabilization policy that reduces the level of GDP is a contractionary policy. Such a policy would aim at
shifting the aggregate demand curve from AD1 to AD2 to close the gap, as shown in Panel (b). A policy to shift
the aggregate demand curve to the left would return real GDP to its potential at a price level of P3.

For both kinds of gaps, a combination of letting market forces in the economy close part of the gap and of
using stabilization policy to close the rest of the gap is also an option. Later chapters will explain stabilization
policies in more detail, but there are essentially two types of stabilization policy: fiscal policy and monetary
policy. Fiscal policy is the use of government purchases, transfer payments, and taxes to influence the level of
economic activity. Monetary policy is the use of central bank policies to influence the level of economic activity.

To Intervene or Not to Intervene: An Introduction to the Controversy

How large are inflationary and recessionary gaps? Panel (a) of Figure 7.19, “Real GDP and Potential Output”
shows potential output versus the actual level of real GDP in the United States since 1960. Real GDP appears
to follow potential output quite closely, although you see some periods where there have been inflationary or
recessionary gaps. Panel (b) shows the sizes of these gaps expressed as percentages of potential output. The
percentage gap is positive during periods of inflationary gaps and negative during periods of recessionary
gaps. The economy seldom departs by more than 5% from its potential output.
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Figure 7.19. Real GDP and Potential Output

Panel (a) shows potential output (the blue line) and actual real GDP (the purple line) since 1960. Panel (b)
shows the gap between potential and actual real GDP expressed as a percentage of potential output.
Inflationary gaps are shown in green and recessionary gaps are shown in yellow.

Panel (a) gives a long-run perspective on the economy. It suggests that the economy generally operates at
about potential output. In Panel (a), the gaps seem minor. Panel (b) gives a short-run perspective; the view it
gives emphasizes the gaps. Both of these perspectives are important. While it is reassuring to see that the
economy is often close to potential, the years in which there are substantial gaps have real effects: Inflation or
unemployment can harm people.

Some economists argue that stabilization policy can and should be used when recessionary or inflationary
gaps exist. Others urge reliance on the economy’s own ability to correct itself. They sometimes argue that the
tools available to the public sector to influence aggregate demand are not likely to shift the curve, or they argue
that the tools would shift the curve in a way that could do more harm than good.

Economists who advocate stabilization policies argue that prices are sufficiently sticky that the economy’s own
adjustment to its potential will be a slow process—and a painful one. For an economy with a recessionary gap,
unacceptably high levels of unemployment will persist for too long a time. For an economy with an inflationary
gap, the increased prices that occur as the short-run aggregate supply curve shifts upward impose too high an
inflation rate in the short run. These economists believe it is far preferable to use stabilization policy to shift the
aggregate demand curve in an effort to shorten the time the economy is subject to a gap.

Economists who favor a nonintervention approach accept the notion that stabilization policy can shift the
aggregate demand curve. They argue, however, that such efforts are not nearly as simple in the real world as
they may appear on paper. For example, policies to change real GDP may not affect the economy for months
or even years. By the time the impact of the stabilization policy occurs, the state of the economy might have
changed. Policy makers might choose an expansionary policy when a contractionary one is needed or vice
versa. Other economists who favor nonintervention also question how sticky prices really are and if gaps even
exist.

The debate over how policy makers should respond to recessionary and inflationary gaps is an ongoing one.
These issues of nonintervention versus stabilization policies lie at the heart of the macroeconomic policy
debate. We will return to them as we continue our analysis of the determination of output and the price level.

Key Takeaways

 When the aggregate demand and short-run aggregate supply curves intersect below potential output,
the economy has a recessionary gap. When they intersect above potential output, the economy has an
inflationary gap.

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  Inflationary and recessionary gaps are closed as the real wage returns to equilibrium, where the
quantity of labor demanded equals the quantity supplied. Because of nominal wage and price
stickiness, however, such an adjustment takes time.
 When the economy has a gap, policy makers can choose to do nothing and let the economy return to
potential output and the natural level of employment on its own. A policy to take no action to try to close
a gap is a nonintervention policy.
 Alternatively, policy makers can choose to try to close a gap by using stabilization policy. Stabilization
policy designed to increase real GDP is called expansionary policy. Stabilization policy designed to
decrease real GDP is called contractionary policy.

THE KEYNESAINA AGGREGATE SUPPLY CURVE

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FIVE DIAGRAMS YOU MUST KNOW TO UNDERSTAND MACROECONOMICS

1. The comprehensive AS diagram- The Keynesian Aggregate Supply Curve

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2. Increase in AD- when the economy has lots of unused resources

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3. Increase in AD- when the economy is at full employment

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 4. Decrease in AS- due to rise in input costs

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5. Successful supply side policies and its impact on AS

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Questions- CAPE PAST PAPERS- HOME WORK

1. Draw AS-AD Model and show how equilibrium is restored in the long run following a decrease on AD.
2. Aggregate demand is the sum of the amount spent by individuals, business and government, plus the
net export of goods and services.

a. Explain why AD increases or decreases as price levels increase or decrease.

b. List three variables other than price which can affect AD.
c. State how THREE variables listed above can affect AD.
d. What is the difference between a Keynesian AS curve and a classical AS curve? Use graphs to
explain your answer.

3. Using aggregate demand and aggregate supply curves to illustrate your points, discuss the impacts of
the following event on the price level (P) and the equilibrium GDP (Y) in the short run.

a. A tax cut holding government purchases constant, with the economy operating near full capacity.
b. An increase in the money supply during a period of high unemployment and excess industrial
capacity.
c. An increase in the price of oil caused by war in the Middle East, assuming that the government
attempts to keep interest rates constant by accommodating inflation.

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