Study Guide Taylor’s University Undergraduate Business Programmes ECN60204 MACROECONOMICS August Semester 2021 TUTORIAL 3 (WEEK 4) CLASS ACTIVITIES: • Recap Lecture 3 • Tutorial exercises LEARNING OUTCOMES: After studying the material in this tutorial you should be able to: ✓ Understand what determines aggregate demand and aggregate supply ✓ Understand the concept of equilibrium and how equilibrium real GDP and prices are determined by the interaction between aggregate demand and aggregate supply. ✓ Appreciate that there are three (3) types of equilibrium ✓ Understand how to analyse the change in equilibrium as a result of a change in aggregate demand or aggregate supply using the AD/AS model. ✓ Understand how inflation and unemployment are caused by aggregate demand and supply fluctuations Main Text: Chapter 24 ✓ Sloman J., Wride A. and Garratt D. (2012) :Chapters 15, 17 & 21. TUTORIAL EXERCISES Tutorial Exercises 1. Outline the factors which determine aggregate demand (AD). What factors explains why the AD curve is downward sloping? Which factors produces a change in AD and results in the curve shifting? Answer: The factors which determine aggregate demand are the price level, the government policies, expectations of households and investment, and changes in foreign variables. The AD curve slopes downward for two reasons: -Wealth effect -Substitution effects which include Interest rate a.k.a Intertemporal substitution effect and International-trade substitution effect The wealth effect is when the price level rises but other things remain the same, when real wealth decreases people will restore it by increasing savings and decreasing the quantity of consumption which leads to a decrease in the quantity of AD. The interest rate or Intertemporal substitution effect is the decision to delay the consumption plan. When the price rises and other things remain the same, interest rates rise due to a decrease in the real value of money. Quantity of AD falls. International-Trade substitution effect. When the price rises in Malaysia, Malaysian goods are comparatively more expensive than other foreign goods. The quantity of AD falls because Malaysians will replace homemade goods with foreign goods. The aggregate demand curve shifts to the right as the components of aggregate demand—consumption spending, investment spending, government spending, and spending on exports minus imports—rise. The AD curve will shift back to the left as these components fall. 2. Outline the factors which determine short-run aggregate supply (SAS) and or long-run supply curve (LAS). Give examples of factors which produce a change in aggregate supply curve? Answer: Long-run Aggregate Supply (LRAS) Short-run Aggregate Supply (SRAS) Factor of Production Factor of Production’s Price Factor Productivity Taxes and subsidies Growth in supply of labour Changes in the quantity and quality of • labour and capital Change in quantity and quality of factors of production Change in cost of production • price of raw materials (inputs) Wages are variable. Wage fluctuate with the real GDP Wages are fixed. Wages rate and prices of demanded. resources are remaining constant. Aggregate supply is graphed vertically on the supply curve Aggregate supply is graphed as an upward sloping curve Relationship between the quantity of real GDP supplied and Relationship between the quantity of real the price level when Real GDP is equal to Potential GDP (long GDP supplied and the price level run) Variables adjust to the state of the economy Price Level, Wages and Expectations Variables do not adjust to the state of the economy Price Level, Wages and Expectations Examples of factors which produce a change in aggregate supply curve: Growth in the supply of labor (increase in factor of production) like population growth. Technological advancements such as getting better machines to do the work. Growth in labor productivity (rise in factor productivity): Physical capital growth - infrastructure, machinery Human capital growth - education, workshops, seminars Technological advances - the discovery and the application of new technologies and new goods such as Artificial Intelligence (AI) and blockchain technology. 3. Draw an aggregate demand and supply diagram to show an economy at Answer: a. full employment equilibrium b. At less than full employment equilibrium. What output gap is evident in the diagram? Recession Gap c. At more than full employment equilibrium. What output gap is evident in the diagram? Inflation Gap 4. Assume that an economy is at full employment. Use an aggregate demand and aggregate supply diagram and explain what happens in the short run as a result of a rise in investment and how it affects real GDP and the price level. Your analysis must include an explanation on: • How and in which direction the AD curve shifts • The disequilibrium that would result i.e. shortage/surplus of goods and services • The effect on price level i.e. rises or fall. • The reaction of the quantity of AD and SAS to the price change i.e. the movement along the 2 curves – a detailed explanation on the wealth and substitution effects is a must in this section. • A conclusion as to what happens to the shortage/surplus of goods and services, the level of real GDP, the overall equilibrium, and the output gap. Answer: • How and in which direction the AD curve shifts Investment is part of AD and any rise in I therefore results in a rise in AD, resulting in a rightward shift of the AD curve. The AD curve will shift to the right. • The disequilibrium that would result i.e. shortage/surplus of goods and services Shortage, as the aggregate demand is more than aggregate supply at point P = 100. • The effect on price level i.e. rises or falls. The price level will rise P = 110 • The reaction of the quantity of AD and SAS to the price change i.e. the movement along the 2 curves – a detailed explanation on the wealth and substitution effects is a must in this section. Due to the price change, AD shifts to the right and the SAS has a movement along the curve due to the price changes Wealth effect: When the price level increases but other factors are constant, the real wealth decreases. Real wealth is the amount of money that is in the bank, stocks, assets that the person owns. The way to restore their real wealth, people start saving up money which decreases the quantity of consumption, and which ultimately leads to a decrease in the quantity of aggregate demand. Substitution effect: When the price rises, households and firms need money to finance, sell stocks and more, therefore they borrow less or withdraw funds causing the real value of money to decrease and interest rate to increase. Thus, the quantity of aggregate demand falls. • A conclusion as to what happens to the shortage/surplus of goods and services, the level of real GDP, the overall equilibrium, and the output gap. • shortage is resolved as quantity of AD and SAS converges at new equilibrium at point C as real GDP rises to $420b. An inflation gap of $20b results between Y = $420 (full employment) and Y=420. Question 5 Long-run adjustment: • At equilibrium point c, there’s an inflation gap of ∆Y=20. Problems with insufficient capacity. Labour shortages will force money wages to rise – production costs rises/firms profits fall – output falls - the SAS curve shifts leftwards. • Shortage of goods and services at P=110 • price level rises to P=115 • The reaction of the quantity of AD and SAS to the price rise – a detailed explanationon the wealth and substitution effects is a must in this section. • A conclusion as to what happens to the shortage of goods and services, the level ofreal GDP, the overall equilibrium, and the output gap. Students must indicate the movement back to full employment at Y=400
