ECON5002 - Intermediate Macroeconomics

Tutorial Questions

Topic: 'The AS-AD Model'

Tutorial 7 (Week Beginning 20 April)

NB: The readings for this tutorial are indicated in Topic 4 of the reading guide.

1. What is the significance of the vertical long run aggregate supply curve at the natural level of income in the AS-AD model?

2. If the actual price level is not equal to the expected price level (i.e. P P^e), what does this imply about the equilibrium position in the AS-AD model? What is the likely effect if, for example, P > P^e?

3. Use the AS-AD analysis to explain the short run effects on real income and the price level of the following events:

(a)an increase in direct government expenditure.

(b)a reduction in the central bank's price target.

(c)a 'mining boom' with a massive increase in export income.

(d)a doubling in the 'Goods and Services Tax' (GST)

4. Consider a deflationary shock to the economy caused by a collapse in world demand and the nation's export income. Using the AS-AD model, explain the adjustment to long-run equilibrium when money wages are flexible. How will your answer change if money wages are rigid downwards? In this case what kind of discretionary policy action may restore long-run equilibrium?

5. Show in the AS-AD model why an expansionary fiscal policy cannot apparently reduce the natural rate of unemployment.

Discussion Questions: Why is it that much of the debate in macroeconomics about the role of government intervention and appropriate policy revolves around the flexibility or inflexibility of wages and prices? In this light, consider for example how this question shapes different arguments on the merit of a restrictive monetary policy aimed at significantly reducing the price level.