3.2 Variations in Economic Activity (AD & AS) (DP IB Economics: SL): Flashcards

A depreciation raises net exports, because exports become less expensive for foreigners while imports become dearer, so exports rise and imports fall.

Disposable income is the money households have left from their wages after paying taxes and receiving any transfer payments.

Aggregate supply is the total supply of goods and services produced within an economy at a specific price level at a given time.

The short run is a period in which wages and other factor prices are inflexible.

The SRAS curve is upward sloping because, as real output rises, firms face higher costs such as wage bills, which push up average prices.

False.

A change in the average price level causes a movement along the SRAS curve, not a shift of the entire curve.

A change in a non-price determinant of supply causes a shift of the entire SRAS curve.

A fall in input costs increases SRAS, shifting the curve to the right as more can be produced with the same money.

The long run is a period in which there is full wage and factor price flexibility.

The two main non-price determinants of SRAS are changes in the costs of raw materials and energy and changes in indirect taxes.

An increase in indirect taxes raises firms' costs and shifts the SRAS curve to the left.

True.

An increase in productivity lowers unit costs, shifting the SRAS curve to the right so output rises at every price level.

When the average price level rises, there is an expansion of real GDP as the economy moves up along the SRAS curve.

The full employment level of output (Y_FE) is the level of output where all available resources are used, corresponding to the maximum output on the production possibilities curve.

In the Monetarist/New Classical view the LRAS curve is perfectly inelastic (vertical) at the full employment level of output.

True.

The Classical view holds that an economy always returns to the full employment level of output in the long run, with only the average price level changing.

An output gap is the difference between the actual level of output (real GDP) and the maximum potential level of output.

Keynes believed the LRAS curve was L-shaped, made up of three distinct sections.

A deflationary output gap occurs when real GDP is less than potential real GDP.

An inflationary output gap occurs when real GDP is greater than potential real GDP.

False.

The Keynesian view holds that an economy may get stuck at an equilibrium well below the full employment level of output, as in the Great Depression.

The Keynesian AS curve is elastic at low output because there is spare capacity, so struggling firms can increase output without raising prices.

In the Keynesian model, government spending can change confidence, known as animal spirits, in the economy.

Output gaps are difficult to measure because it is hard to know the maximum productive potential of an economy.

A rightward shift of the LRAS curve represents an increase in the potential output of the economy.

Efficiency improvements are process innovations that result in a productivity improvement, such as moving from labour-intensive to automated car production.

The LRAS curve is shifted by changes in the quality or quantity of factors of production, technological advances, efficiency improvements, and changes in institutions.

False.

Only LRAS factors change the potential output of the economy; changes to SRAS do not.

Improving the skills of workers raises the quality of a factor of production and shifts the LRAS to the right.

A change in migration policy can increase the quantity of labour, shifting the LRAS to the right.

When the LRAS shifts right in the Classical model, the extra supply allows the average price level to fall while output increases.

Technological advances often improve the quality of the factors of production.

True.

An increase in the LRAS raises potential output, which corresponds to an outward shift of the PPC.

Changes in institutions can increase potential supply by providing more access to finance and by introducing legislation that makes it easier for new firms to enter markets.

Potential output is the maximum level of output an economy can produce when all of its factors of production are fully used.

Short-run equilibrium occurs where aggregate demand (AD) intersects short-run aggregate supply (SRAS).

Classical long-run equilibrium occurs at the intersection of LRAS, SRAS and AD, at the full employment level of output (Y_FE).

In the Classical model, Y_FE is considered equal to the natural rate of unemployment.

True.

Unemployed workers accept lower wages, reducing costs of production so SRAS shifts right and output returns to Y_FE at a lower average price level.

SRAS shifts left because rising prices lead workers to demand higher wages, which increases the costs of production.

The self-correcting mechanism is the Classical belief that in the long run an economy always returns to its full potential output, with only the average price level changing.

True.

Keynesian economists believe an economy can settle in long-run equilibrium at any level of output, including one well below full employment.

Wages may be sticky downwards because of minimum wage laws, trade unions and long-term employment contracts that prevent wage decreases.

Keynes argued the government needed to intervene with significant spending to change the mood in the economy.

Classical thinking holds that supply-side policies are more effective than demand-side policies for generating economic growth.

Animal spirits are the human emotions that drive financial decisions during times of uncertainty or market volatility.

He meant that relying on markets self-correcting in the long run is flawed, because the long run can be a very long period during which severe recessionary gaps cause lasting harm.