Toni Prskalo Economics 11F Neo-classical AD/AS Model Questions: 1.

Why does the neo-classical aggregate supply curve always lead to an equilibrium level of national output equal to the full-employment level of real GDP? It leads to equilibrium because the model implies that an increase in aggregate demand will lead to an increase in output and therefore prices. However, in the long run the economy would have gone towards full employment naturally and the aggregate supply curve would be vertical as the increase in price would be inflationary. 2. The vertical AS curve above is sometimes referred to as the flexible -wage and flexible-price model of the macroeconomy. Why must wages and prices be perfectly flexible for this model to be an accurate representation of a nations economy. Flexible wages and flexible employment helps to ensure that markets clear rapidly eliminating any excess supply or demand, so economies automatically move into long run equilibrium at potential output. As this economic theory states that forces are natural and aggregate supply and aggregate demand meet naturally, wages and prices adjust in the long run to balance the market. 3. Hayek was an advocate for free markets, he felt that government intervention in a nations economy would only interfere and disrupt the efficient allocation of resources. How does the model above reflect his belief that governments cannot improve a nations level of output beyond what the free market is able to achieve? The level of aggregate supply is identical, regardless of any government intervention, meaning that although there may be changes of the price level of the economy, the real GDP cannot be altered by the government. 4. Do you believe that the neo-classical model of aggregate supply is representative of the real world? Why or why not? What evidence is there from recent history that the model is or is not accurate? No as the model does not examine the role of growth and development of a national economy and instead is too orientated towards microeconomics. An example is the downturn in the United States between 1929-1933 wherein government intervention was necessary to stimulate the economy and the recovery could not occur without it.

Keynesian AD/AS Model: 1. Based on the model above, which level of aggregate demand corresponds with the macroeconomic goals of full-employment and stable prices? AD2 2. Changes in which factors could cause aggregate demand to shift from AD2 to AD3? If AD falls to AD3, what happens to the price level in the economy? What happens to the level of output of goods and services? What happens to employment and unemployment? AD would shift from AD2 to AD3 in the case of a downturn or recession. Price levels would decrease as well as the level of output of the economy. Employment would decrease (therefore increasing unemployment) as resources are allocatively inefficient. 3. Sometimes the Keynesian AS model is known as the sticky-wage and sticky-price model. How does the model reflect the idea that wages are downwardly inflexible, in other words, will not fall even if demand for goods and services fall? For what reasons might wages in an economy be downwardly inflexible (in other words, not fall even as total demand in the economy falls)? Wages may not fall as total demand in the economy falls as wages are typically contractual in the short run and therefore cannot adjust proportionately to changes in the economy (if total demand falls). Overall, When the price level rises, the nominal wage remains fixed because this is solely based on the monetary amount of the wage. The real wage falls because this is based on the purchasing power of the wage. A higher price level means that a given wage is able to purchase fewer goods and services. 4. How realistic is the Keynsian model of aggregate supply in the real world? Semi-realistic. While wages are not set, and people often have to take pay cuts as levels of profit decrease. a. Can you point to any evidence from the last few years that it might be correct (in other words, that a fall in AD will lead to decrease in national output)? Find data on the GDPs of two Western European countries from 2008 and 2009 to support your findings. In Ireland the GDP growth in 2008 was -1.7% in 2008, and -7.1% in 2009, indicating the national output decreased with the fall in GDP. In Denmark the GDP growth in 2008 was -0.8% compared to -5.7% in 2009. b. Can you point to any evidence from the last few years that the model might be flawed (in other words, that a fall in AD actually does lead to a fall in the price

level)? Find data on inflation in the same two Western European countries to examine whether or not wages and prices are completely inflexible downwards as the model suggests. The model has not proved to be flawed. IB Economics AD/AS Model: 1. How does the above model represent a compromise between Keynes and the neo-classical view of aggregate supply? This model represents a compromise between Keynes and Hayeks views of aggregate supply as both are incorporated. The curve that is similar to the Keynesian model is denoted as the SRAS curve in this diagram and the neoclassical model as the LRAS curve. Much as the views of the Keynesian model are now used in the short run this is actually quite fitting because according to Keynes wages and prices are inflexible, meaning the economy could be stuck in the short run where prices are fixed; the curve also represents his views that a rise in real GDP/output does not have to lead to a rise in resource prices and wages. Hayeks views are also kept in that the LRAS is vertical at the level of potential GDP and so any movement to the left or right would cause inflationary or deflationary gaps. 2. Why are there two aggregate supply curves? What is the difference between the two? One shows the short run time period where wages and resource prices are fixed and at low levels of real GDP an increase in output does not really cause an increase in price. In the short run an increase in price is an incentive to increase real output however in the third section of the SRAS curve maximum output has been reached and the economy cannot produce any more. The other curve shows the long run aggregate supply and this is also equal to the potential GDP where there is full employment. A rise in price does not increase the real output produced. 3. What happens in the SHORT-RUN when AD falls from AD2 to AD3 to the price level and output? What will happen in the long-run? In macroeconomics, the shortrun is known as the fixed-wage period and the long-run the flexible-wage period. The main factor that can shift the SRAS curve is the level of wages in the economy (in other words, a change in wages will shift the SRAS). How does this help explain the adjustment from the short-run equilibrium and the long-run equilibrium following a fall in AD? In the short run when AD falls from AD2 to AD3 there will be a fall in price from P2 to P3 and a decrease in the real output to Y3. In the long run the fall in price is matched will a fall in wages and resources prices (which are now flexible) so firms can keep their profitability. These reduced costs will then shift the SRAS curve to the right which means that the equilibrium in the long term is now at a

lower price than before, potential real output is equal to the real output produced. 4. What happens in the SHORT-RUN when AD increases from AD2 to AD1? What will happen in the long-run? How does the long-run flexibility of wages explain why output always seems to return to its full employment level of output in the longrun? In the short run when AD increases from AD2 to AD1 there will be an increase in price from P2 to P1 and the real output produced. This will cause an inflationary gap where GDP is more than potential GDP and unemployment less than the natural rate of unemployment. The increase in price is matched with an increase in wages and resource prices which increases the firms costs and so the SRAS curve shifts to the left and output decreases. In the long term real output is equal to potential output now only at a higher price. 5. What does the model above indicate about the possible need for government intervention to help an economy achieve its macroeconomic goals of fullemployment and price level stability in the short-run? The model shows that aggregate demand plays a vital role in achieving the macroeconomic aims of governments to achieve full employment. The government can increase or decrease if necessary- the aggregate demand in an economy by using monetary and fiscal policies. For example decreasing income tax (expansionary fiscal policy) so consumers have more disposable income and so increase their spending.