ECON 102 Tutorial: Week 23
Ayesha Ali
www.lancaster.ac.uk/postgrad/alia10/econ102.html
a.ali11@lancaster.ac.uk
office hours: 8:00AM – 8:50AM tuesdays LUMS C85
Today’s Outline
 Week 23 worksheet – Revision of ISLM and Aggregate
Demand/Aggregate Supply
 Additional Slides at the end contain material from past
exams – these might be helpful for your revision, so I’ve
included them.
 If you have not picked up Exam 3, you may pick up from
my office.
Question 1
Consider a fall in the general level of prices from PA to PB, which results in a movement along
an aggregate demand curve.
Use the geometry of ISLM, the Liquidity Preference schedule and the Investment Demand
schedule, to explain the increase in output from YA to YB.
1. Liquidity Preference schedule
2. Investment Demand Schedule
1. With a fall in the general level of
prices (P), real balances (M/P) rise.
By Keynes’s liquidity preference
theory of interest rate
determination, excess real
balances force up bond prices so
that interest rates fall.
3. IS-LM Model
4. Aggregate Demand Curve
2. & 3.This stimulates investment
expenditure and real income (Y)
rises.
4. From this, we can understand
that the relationship between P
and Y is an inverse relationship.
Question 2
Now, let’s look at the impact on Aggregate Supply of an increase in
money wages:
If money wages increase,
that shifts AD to the right,
so that output is at Q2.
If labour is not
involuntarily unemployed
(meaning if Q2 is not Q*),
then the rise in the
general level of prices will
be countered by a rise
money wages (the AS
schedule swings
upwards).
Question 3
What would be the locus of the Aggregate Supply schedule, if money
wages and prices always changed by the same proportionate rate?
The AS Schedule would be vertical at the point of:
(i) ‘full-employment’ income/output;
(ii) (ii) the ‘natural rate of unemployment’.
Question 4(a)
Consider a shift to the right of the aggregate demand
curve.
What might happen to the general level of prices and to
the level of employment?
Prices or Employment or Both may increase, depending
on the slope of the AS Curve.
Both↑:
only Prices ↑:
only Employment ↑:
Question 4(b)
Which is more likely and when?
Short-Run: Both Output & Prices ↑ (when AS is upward-sloping)
Only Output ↑ (AS is horizontal – a very deep recession)
Long-Run: Only Prices ↑
– fiscal deficit spending increases the volume of bonds/currency in
circulation which is (potentially) inflationary.
Both↑:
only Prices ↑:
only Employment ↑:
Question 4 ctd.
Consider a shift to the right of the aggregate demand curve.
c) Explain the relevance of aggregate supply determined to
your answer to b).
If, as retail prices begin the rise, there is no price/wage
spiral, then inflation is unlikely; but, by the experience of the
UK in the 1970s, neither high unemployment nor ‘incomes
policy’ inhibit a price/wages spiral.
d) Which variable remains constant along a given aggregate
supply curve? Explain the relevance of that constancy.
Money wages stay constant in the AS curve.
If we assume that money supply is constant then, this implies
that if prices rise, in order to compensate either wages would
go up or unemployment would go down.
Additionally, if we assume that money wages stay constant
then the rise in the general level of prices is assumed to NOT
trigger a price/wage spiral.
Question 4(e)
How would you represent a price/wage spiral within the
geometry of aggregate demand and aggregate supply?
Note: This is what we look at in Question 2, as well.
Question 5(a)
Which circumstances are represented by an Aggregate Supply
schedule that is vertical?
This is the Long-run equilibrium (LRAS), if we were at full employment
or the natural rate of unemployment (Q = Q*).
In this case, ‘expansionary’ macroeconomic policy generates inflation
only.
Note: This is what we look at in Question 4(b).
Question 5(b)
Which circumstances are represented by an Aggregate Supply
schedule that is horizontal?
This would occur in a deep recession or when there is excess capacity.
Unit costs of production are unchanged as income/output rises
Note: This is what we look at in Question 4(b).
Question 5(c)
Which circumstances are represented by an Aggregate Supply schedule that is
upward sloping (left to right)?
The case that Keynes addresses in TGT: ‘expansionary’ macroeconomic policy raises
both output and unit costs which, passed on as higher prices, reduces real wages
and eliminates involuntary unemployment.
Note: This is what we look at in Question 4(b).
Question 6
The following passage is from Keynes’s General Theory:
‘Men are involuntarily unemployed if, in the event of a small rise in the price of wage-goods,
relative to the money-wage, both the aggregate supply of labour willing to work for the
current money-wage and the aggregate demand for it at that wage would be greater than the
existing volume of unemployment.’
Using modern terminology and vocabulary, rewrite the passage and define words in bold.
Gerry’s re-write:
a Suppose price inflation erodes the purchasing power of existing earnings. If the effect were
to increase (beyond the current level of employment) both (1) the number of individuals
willing to work at those earnings levels, and (2) the number of jobs that are available at those
earnings levels, then involuntary unemployment could be said to exist.
b the price of wage-goods:‘cost of living’
the money-wage‘retail prices’; ‘earnings’
Question 7(a)
Search the internet with the string Keynesian “fixed price model” then, in your own
words, explain the essential assumption of such models
The assumption of a Keynesian Fixed Price Model:
The impact of aggregate demand management policies is based on
factors other than the general level of prices.
(Gerry suggests that this assumption is highly dubious.)
Some points that Gerry makes:
 a model delivers results determined by its assumptions;
 all causation originates from exogenous changes (about which
we know nothing!)
Question 7(b)
Comment on the plausibility of that assumption.
By Keynes’s General Theory, an economy in recession should have no fear of inflation. However, once full employment
is reached, inflation sets in. Two key passages are:
‘ .. an increase in the quantity of money will have no effect whatever on prices, so long as there is any unemployment,
and that employment will increase in exact proportion to any increase in effective demand brought about by an increase
in the quantity of money; whilst as soon as full employment is reached, it will thenceforward be the wage-unit and prices
which will increase in exact proportion to the increase in effective demand’ (TGT: 295)
‘When a further increase in the quantity of effective demand produces no increase in output and entirely spends itself
on an increase in the cost-unit fully proportionate to the increase in effective demand, we have reached a condition
which might be appropriately designated as one of true inflation’ (‘ .. an increase in the quantity of money will have no
effect whatever on prices, so long as there is any unemployment, and that unemployment will increase in exact
proportion to any increase in effective demand brought about by an increase in the quantity of money; whilst as soon as
full employment is reached, it will thenceforward be the wage-unit and prices which will increase in exact proportion to
the increase in effective demand’ (TGT: 303)
Keynesians argue that short-term measures (i.e., raising public expenditure) to lift an economy from recession, no
inflationary consequences because of spare productive capacity and unemployed labour. Their argument is that shortterm solutions have no long-term adverse consequences:
The long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy,
too useless a task if in tempestuous seasons they can only tell us that when the storm is past the ocean is flat again.
(Keynes 1923)
‘Are we not told that ‘since in the long run we are all dead’, policy should be guided entirely by short-run considerations?
I fear that these believers in the principle of après nous le déluge may get what they have bargained for sooner than they
wish’ (Hayek, 1941)
Next Class
 Last Class!
 Week 24 Worksheet
Practice Past Exam Questions
Please Note: Solutions are not given to tutors for these
questions. The solutions I’ve prepared here are my best
guess – I cannot guarantee they are correct.
Note: View in slideshow mode for suggested solutions.
Fiscal monetarists argue that inflation is a
consequence of excessive growth in:
a) revenue from taxation
b) sovereign debt
c) the money supply
d) national output
2013 Exam Q36
As defined in Keynes’s General Theory,
‘involuntary unemployment’ relates to
individuals whose employment
prospects would be raised by
a) a rise in the price of wage goods (i.e., a rise in
the cost of living)
b) a fall in the price of wage goods (i.e., a fall in
the cost of living)
c) greater trade union participation
d) a shift to capital-intensive production methods
2013 Exam Q30
Labour Market:
real wage (W/P)
W/P1
MPL
E1
L1
‘Men are involuntarily unemployed if, in the event of a small rise in the price
of wage-goods (P2 > P1) relative to the money-wage (W), both the aggregate
supply of labour willing to work (L2) for the current money-wage and the
aggregate demand for it at that wage (E2) would be greater than the existing
volume of employment (E1)’ (Keynes, 1936)
2013 Exam Q30
Assuming national income is at the full
employment level, which one of the
following policies would be most likely
to lead to inflation?
a) A fall in taxation with unchanged
Government spending
b) A reduction in investment by firms
c) A fall in exports
d) An increase in labour productivity with no
corresponding increase in wages
2014 Exam Q27
In the IS-LM model, a fall in the money
supply will:
a) Shift the LM curve downwards
b) Cause the interest rate to rise and so raise
investment
c) Cause the interest rate to fall and so raise
investment
d) Cause national income to fall and the interest
rate to rise
2014 Exam Q30
Causation is determined in Keynesian
macroeconomic models by
a) consumers’ behaviour
b) changes in exogenous variables
c) investors’ behaviour
d) changes in endogenous variables
2014 Exam Q40
Keynes’s analysis of the demand to
hold money (i.e., ‘liquidity preference’)
assumes that asset holders speculate
in regard to
a) the exchange rate
b) prices of consumption goods
c) prices of capital goods
d) bond prices
2014 Exam Q34
Money illusion is people failing to
distinguish between
a) Real and money wages
b) Real and nominal interest rate
c) Real and nominal money balances
d) All of the above
2014 Exam Q33
Which aggregate demand curve
indicates a situation of inflationary
The diagram below refers to questions 31 and 32 and
demand?
shows aggregate demand (D) curves and an aggregate
a)D1
b)D2
c) D3
d)D4
supply curve (S) for an economy.
2014 Exam Q33
An increase in aggregate demand
above D3 will lead to:
a) More goods and services
being produced
b) Fewer goods and services
being produced
c) The same amount of
goods and services being
produced
d) It is impossible to tell
The diagram below shows aggregate demand
(D) curves and an aggregate supply curve (S)
for an economy.
2014 Exam Q34