Question

a. If the above graph is a depiction of the state of the economy as it is now, what would have to happen for there to be stagflation?

b. What is used to measure the price level in the AS-AD model above?

c. What does the Potential GDP curve represent and what is its relationship to the price level?

d. Explain why it is possible for production to be greater than Potential GDP.

e.Give three reasons that the AD curve slopes downward.

f. Give three theories as to why the Short Run Aggregate Supply curve slopes upward.

g. Give one reason for each curve, that would cause the curve to shift.

Answer 1

If the AD curve moved out and to the right, and the SRAS curve moved up and to the left, there would be stagflation.

The intersection of the AD and SRAS curves.

The potential GDP is the sustainable level of GDP and is represented by the level of GDP consistent with the LRAS curve. It is the same regardless of the price level because in the long term all prices adjust.

Production can be temporarily higher than sustainable GDP due to short term fluctuations in demand and supply. Howver there are forces (at least in classical economics) thet will bring GDP back to the potential sustainable level.

AD curve slopes downward due to

Income effect. People can buy mjore with their icomes when the price levle is lower, so quantity demanded increases.

Export effect. When price level is lower, foreign currecies can buy more US dollars, so there is a higher demand for exports

Investment effect. A low price level is consistent with lower interest rates, so more money is borrowed for investment in plant and equipment and consumer big ticket purchases.

SRAS slopes upward because a higher price level increases profit margins, as resource costs are fixed in the short term. This causes suppliers to supply more.

AD curve would shift with a tax cut, or more government spending.

SRAS curve would shift with a supply shock (like oil prices suddenly going up due to Middle East turmoil).

LRAS curve would shift due to technology improvements, more resources, improved economic freedom due to government encouraging free trade, or promoting competition, or enforcing contacts and provate property rights.