Economics - AS AD (Macro)

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AS AD

Define and distinguish between short-run aggregate

supply and long-run aggregate supply.

Short-run aggregate supply is the relationship between the quantity of real GDP

supplied and the price level when the money wage rate, the prices of other

resources and potential GDP remain constant. A rise in the price level with no change in the money

wage rate and other factor prices will drive a rise in the quantity of real GDP supplied. The

short-run aggregate supply curve (SAS) is upward sloping.

This is shown in the following example where

Long-run aggregate supply is the

relationship between the quantity of real GDP supplied and the price level when

the money wage rate changes in step with the price level to maintain full

employment. The quantity of real GDP supplied at full employment

equals potential GDP and this quantity is independent of the price level. So

the long-run

aggregate supply curve (LAS) is vertical at potential GDP.

This can be seen in the following

Define long-run macroeconomic equilibrium. With the use of diagram,

explain how the long-run equilibrium is restored in the economy when the money

wage rate is too low in the short-run.

Long-run macroeconomic equilibrium occurs when

real GDP equals potential GDP − when the economy is on its LAS curve. Long-run

equilibrium occurs at the intersection of the AD and LAS curves.

Figure 1 shows how the

long-run equilibrium is restored in the economy when the money wage rate is too

low in the short-run. The horizontal axis shows real GDP, while the vertical

axis shows the price level. AD denoted

the aggregate demand curve, LAS denotes the long-run aggregate supply curve,

and SAS2 to SAS* denote the short-run aggregate supply curves.

When the money wage rate

is too low, real GDP is above potential GDP (in Figure 1, potential GDP is

$1,300 billion, while real GDP is $1,350 billion), and the unemployment rate is

below the natural rate of unemployment. This means that demand for labour is

larger than supply of labour, and as a consequence, the money wage rate rises.

As the money wage rate rises, firms reduce their production because of the

increase in the price of resource (i.e. labour), thus the short-run aggregate

supply curve shits from SAS2 to SAS* in Figure 1, which

restores the long-run macroeconomic equilibrium.

Explain how monetary policy and fiscal policy affect aggregate demand

in the quantity of money increases

buying power and increases aggregate demand. Opposite happens when the quantity of money

decrease, then buying power decreases and aggregate demand

decreases. A cut

in interest rates increases expenditure and increases

aggregate demand. Opposite happens when interest rate decrease, expenditure

decrease thus resulting in a decrease in aggregate demand.

Fiscal policy is the government’s attempt

to influence the economy by setting and changing taxes, making transfer

payments, and purchasing goods and services. A tax cut or an increase in transfer payments

increases households’ disposable

income − aggregate income minus taxes plus transfer payments. An

increase in disposable income increases consumption expenditure and increases

aggregate demand. Because government expenditure on goods and services is

one component of aggregate demand, an increase in government expenditure

increases aggregate demand.