Questions Chapter 4
1
What are the chief limitations of the income-expenditure model? Discuss the shape and
properties of the SAS. What kind of an SAS curve has been assumed in the incomeexpenditure model?
The income-expenditure model is only a simple model and is essentially a fixed price
model. There is no role for changes in prices or changes in the supply of money (see
page 102).
Shape and properties of the SAS curve (see page 103-6):
The SAS curve shows the price level required for firms to be willing to produce each
possible level of output. When drawing the SAS some of the factors are assumed
constant:
 the basic wage rate
 price of imported goods
 productivity of the workforce
 profit per unit.
At low levels of output there is spare capacity and the SAS is relatively flat.
With increasing output existing plant and machinery are more fully utilised.
Bottlenecks and shortages of appropriately skilled labour may occur; it becomes
relatively more costly to produce extra output and the SAS curve starts to slope
upwards.
At near full capacity it becomes more and more costly to increase output. The
SAS curve begins to slope upwards more steeply as the economy approaches full
capacity.
In the income/expenditure model the SAS curve is assumed to be horizontal –firms
would supply any amount they could sell at existing prices.
2
What is the justification for the long run AS curve being vertical?
At the LAS: all resources are allocated with maximum efficiency (i.e. at the limits of
the PPF). At full capacity level, firms cannot exceed this level on a sustained basis no
matter what price is charged (see text page 107).
3 How could New Zealand policymakers attempt to shift the long run AS curve to the right?
What factors have shifted it to the right in the last ten years?
Policy makers might shift the LAS out to the right by:
 An increase in investment and introduction of new technology and better
forms of organisation (increasing productive capacity)
 an increase in the labour force (immigration, higher participation, means more
output can be produced from existing capital stock)
 an increase in skill of labour force (human capital – increase in productive
capacity via improvement in productivity).Labour market policies to
encourage the retraining of labour should improve productivity.
The LAS has shifted to the right over the last ten years as net immigration has added
to the labour supply. The adoption of new technology such as in the communications
has increased productive capacity. There has been more investment in human capital
and labour market policies have assisted firms in making better use of their capital
stock.
Long-term sustainable growth rate reflects the speed at which the LAS curve is
shifting outwards. The average growth rate over the last 15 years of the past century
was low indicating that growth in LAS was weak. More recently there has been a
modest improvement in the long-run sustainable growth rate.
4
What is stagflation, and what could cause it to occur? How does it differ from an
inflationary gap?
Stagflation is the combination of inflation and rising unemployment. It may occur if
the SAS shifts inward. (The AD may be shifting out slowly at the same time.) Hence,
we tend to get rising prices and rising unemployment (as income levels fall) see
Figure. 4.10. Stagflation may also lead to an inflationary spiral developing (see Figure
4.11).
Stagflation in the 1970s was triggered by the supply shocks (oil shocks). Import and
transportation price rises caused the shift in of the SAS, while aggregate demand was
expanding only slowly. In the mid 2000s the rising world price of oil may once again
have a stagflationary impact.
An inflationary gap is when the economy is operating (temporarily) beyond the
full employment level (Yf) and combines inflation with low unemployment.
The two situations are illustrated below.
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5
New Zealand was officially ‘in recession’ in 1998. Draw a recessionary gap diagram and
explain carefully how the self-correcting mechanism might, in theory, ‘cure’ the problem.
In fact the economy grew strongly as exports recovered and domestic spending increased.
Sketch this on your diagram.
Unemployment should lead to wage reductions (or less rapidly rising wage rates),
causing lower costs for firms.
 This shifts the SAS curve out, as firms produce more at each price level. The
economy moves down the AD curve, prices fall and output rises.
 The increased consumption may be because consumers feel wealthier (lower prices)
and buy more; firms invest more (lower interest rates) and overseas countries
purchase more goods because NZ is more competitive.
Note: if AD is steep, the self-correcting mechanism will be ineffective. The process
may also be very slow.
Actual recovery since 1998 began from export recovery from lower $NZ. This shifted
the AD curve outward while the SAS also shifted up because of higher import prices.
Movement of SAS was also influenced by tariff reduction and parallel importing
(moves SAS down by making imports cheaper), and by ending of the drought (moves
SAS outward). Inflationary pressures became evident by 2000, and by early 2004 the
NZ dollar was again at historic highs with some evidence the economy was slowing .
(Note that SAS curve could shift up or down, depending on the net effect of the
various factors influencing it. By late 2000 it was probably shifting up because of the
impact of higher oil prices and the effect of the lower $NZ on import prices.)
7. What are the factors today that are impacting on SAS and AD? What is the overall effect on
(Y) and (P)?
Answers to this question will probably include discussion of:
 the increase in oil prices especially in 2004 (affecting SAS)
 Impact of government’s budget (increased transfers to families in 2004)
 political events (affecting AD via impact on confidence and thus on spending
plans)
 business confidence (affecting AD via impact on spending plans)
 the fortunes of the export sector reflecting world markets (affecting AD)
 exchange rate changes (affecting both AD and SAS)
 impact of labour laws, and other government policy (affecting SAS)
 tax changes (affecting AD, and also SAS if they impact on business costs)
 changes in tariff policy, if any (affecting SAS).