Macroeconomics Chapter 9: Adjustment, Multiplier, AD–AS, and Automatic Stabilizers — Guided Study

Q1. What is the adjustment process from the short run to the long run in the AD–AS model?

Background

Topic: AD–AS Model Adjustment (Chapter 9)

This question tests your understanding of how the economy returns to potential output (Y*) after a shock, focusing on the role of wage and cost adjustments, and the shifting of the Short-Run Aggregate Supply (SRAS) curve.

Key Terms and Concepts:

• SRAS (Short-Run Aggregate Supply): Shows output supplied at different price levels when some input prices (like wages) are sticky.

• LRAS (Long-Run Aggregate Supply): Vertical at potential output (Y*), determined by resources, capital, labour, and technology.

• Factor Prices: Wages, rents, and interest rates that adjust in response to output gaps.

• Output Gap: The difference between actual GDP and potential GDP (Y*).

• Sticky Wages: Wages that adjust slowly, especially downward.

Step-by-Step Guidance

1. Recall that in the short run, wages and some input prices are sticky, so the SRAS curve can shift in response to changes in costs.

2. When actual GDP is not equal to potential GDP (Y*), there is either a recessionary gap (GDP < Y*) or an inflationary gap (GDP > Y*).

3. In a recessionary gap, unemployment is high, leading to downward pressure on wages and costs. In an inflationary gap, labour shortages push wages and costs up.

4. As wages and costs adjust, the SRAS curve shifts: falling wages shift SRAS right (downward), rising wages shift SRAS left (upward).

5. This adjustment continues until actual GDP returns to potential GDP (Y*), at which point the economy is back in long-run equilibrium.

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Q2. If the economy is in a recessionary gap, what happens to wages over time?

Background

Topic: Output Gaps and Wage Adjustment

This question checks your understanding of how wages respond to a recessionary gap and how this affects the SRAS curve.

Key Terms and Concepts:

• Recessionary Gap: Actual GDP is less than potential GDP (Y*).

• Labour Market: High unemployment means excess supply of labour.

• Wage Adjustment: Wages tend to fall when there is excess supply of labour.

Step-by-Step Guidance

1. Identify that a recessionary gap means GDP < Y*, so unemployment is higher than normal.

2. With high unemployment, there is excess supply of labour, which puts downward pressure on wages.

3. As wages fall, firms' costs decrease, which encourages firms to increase output at each price level (SRAS shifts right).

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Q3. If actual GDP is greater than potential GDP, what kind of gap is it?

Background

Topic: Output Gaps

This question tests your ability to identify the type of output gap and its implications for the labour market and wage adjustment.

Key Terms and Concepts:

• Inflationary Gap: Actual GDP > Potential GDP (Y*).

• Labour Shortage: Unemployment is below the natural rate, so firms compete for workers.

• Wage Adjustment: Wages tend to rise in an inflationary gap.

Step-by-Step Guidance

1. Recognize that when GDP > Y*, the economy is producing above its sustainable capacity.

2. This creates a labour shortage, leading to upward pressure on wages.

3. As wages rise, production costs increase, causing the SRAS curve to shift left (upward), moving GDP back toward Y*.

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Q4. How does the size of the simple multiplier affect the slope of the AD curve?

Background

Topic: Multiplier and Aggregate Demand (AD) Slope

This question examines the relationship between the multiplier and the responsiveness of real GDP to changes in the price level (the slope of the AD curve).

Key Terms and Formulas:

• Simple Multiplier: Measures how much equilibrium GDP changes in response to a change in autonomous expenditure.

• Multiplier Formula:

$Multiplier = \frac{1}{1 - [MPC(1-t) - m]}$

• AD Curve: Shows the relationship between the price level and real GDP demanded.

Step-by-Step Guidance

1. Recall that a larger multiplier means spending changes have a bigger effect on GDP.

2. When the multiplier is large, a change in the price level causes a larger change in equilibrium GDP, making the AD curve flatter.

3. Conversely, a smaller multiplier means the AD curve is steeper, as GDP responds less to price changes.

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Q5. How do automatic stabilizers affect the size of the multiplier and GDP stability?

Background

Topic: Automatic Stabilizers and Economic Stability

This question tests your understanding of how features like progressive taxes and unemployment insurance affect the multiplier and the stability of real GDP.

Key Terms and Formulas:

• Automatic Stabilizers: Elements of the tax-and-transfer system that automatically change with income or unemployment, stabilizing GDP.

• Multiplier Formula:

$Multiplier = \frac{1}{1 - [MPC(1-t) - m]}$

• GDP Stability: How much real GDP fluctuates in response to shocks.

Step-by-Step Guidance

1. Recognize that automatic stabilizers (like progressive taxes and EI) increase leakages from the spending stream, reducing the multiplier.

2. A smaller multiplier means that changes in autonomous spending or shocks have a smaller effect on equilibrium GDP.

3. This reduction in the multiplier leads to more stable real GDP, as the economy is less sensitive to shocks.

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