Tuesday 23 February

In the Aggregate Demand/Aggregate Supply model of the macro economy, AD slopes down, LRAS is vertical, and SRAS slopes up. In one sentence each, give one reason why

The comments given are not "one sentence one reason," they give fairly complete explanations; you only had to give one reason for each of 1. and 3.

The AD/AS 'model' is comparable to a Demand and Supply model for a market for a single commodity, except that it is a bit closer to a metaphor because it is dealing with aggregates, i.e. total output and its price level. Therefore on the diagram we measure real GDP on the horizontal axis, and the price level of GDP [i.e. output price level] on the vertical axis, ceteris paribus -- i.e., everything except the real GDP of the US, and the price level of US GDP, held constant.

  1. AD slopes down

AD is Aggregate Demand, how much real GDP people want to buy at different price levels. AD sloping down means that, everything else constant, if the price level for US output goes down, the aggregate amount of real US GDP people want to buy increases.

There are three major reasons:

    1. The amount of money in the economy, held by people, has not changed. If the price level has gone down, it buys more real goods and services, i.e. real GDP. So real wealth has gone up, people are richer, and they will want to buy more -- so AD slopes down. Called the real balance effect.
    2. Because the same amount of money at the lower price level now buys more goods, people will need to hold less money; but the same amount of money is there. The opportunity cost of holding money is the interest rate; therefore to persuade people to hold the same amount of money as before, interest rates will have to fall; spending that is financed by borrowing (investment, consumer durable purchases) thus becomes cheaper, so people will want to buy more -- so AD slopes down. An interest rate effect.
    3. The US price level has changed, but foreign prices have not changed (ceteris paribus). Thus if the US price level goes down, US goods are now cheaper relative to foreign goods, whose prices have not changed. US purchasers will substitute away from imports toward home-produced goods, foreign purchasers will substitute away from their own goods toward US exports -- so imports (M) decline, exports (X) increase, expenditure on real GDP increases [GDP = C + I + G + (X - M)]. International substitution effect.
  1. LRAS is vertical
  2. LRAS is Long Run Aggregate Supply, how much real GDP producers want to sell at different price levels, given enough time for input prices to adjust to the different output price level.

    We just assume that, given population, capital stock, technology, and institutional arrangements, the economy has a given capacity to produce output, consistent with the NAIRU or natural rate of unemployment, and the producers in the economy will want to supply that quantity of real GDP once they have time to fully adjust to a new output price level, whatever that output price level.

  3. SRAS slopes up

SRAS is Short Run Aggregate Supply, i.e. how much real GDP producers want to sell at different output price levels, given that they have not yet had time to get out of long run contracts or other commitments, so that some input prices have not yet had time to adjust fully to the new level of output prices [implicitly, we assume that in the long run input prices and output prices will be in a relationship to each other such that at the NAIRU, the typical firm is making only normal rates of return, i.e. zero economic profit]. There are two main reasons SRAS slopes up:

    1. If output price level increases, but at least some input prices have not changed yet, the profit margins of at least some firms will have increased, and those firms will respond by producing and wanting to sell more output, i.e. the higher price level induces firms to offer more real output for sale, SRAS slopes up.
    2. Firms may initially confuse an increase in the price level with an increase in the price of their output, i.e. mistake a general price level increase for an increase in the relative price of what they produce; thinking that the price of their output has increased while other prices remain unchanged, they perceive an increase in profit opportunities and increase output, how much they want to sell. So SRAS slopes up.