1.

(4MA310) The aggregate demand curve assumes that changes in the price level affect
real wealth (the wealth effect, together with international trade, and interest rate affects
the value of our money=our purchasing power. Aggregate demand depends on
consumers having lots of disposable income for goods and services)
2. A high marginal propensity to consume implies low marginal propensity to save.
Again, connected with the wealth effect. MPC on a high level happens when consumers
have high trust in the economy; that is, they are paid high wages and expect to have
high income levels in foreseeable future. Because of this trust that they can earn high
income and keep earning it, they do not see many reasons to save, hence the low
marginal propensity to save. Usually, this happens during an expansionary phase of the
business cycle. In a recession, the opposite will be true: there will be high propensity to
save and low propensity to consume (they always have an inverse relationship).
3. The short-run aggregate supply (SRAS) curve is influenced by factors that affect
production costs and the overall supply capacity of the economy. Therefore:
a. The price level: Changes in the price level do not cause the SRAS curve to shift;
instead, they cause movements along the curve. Therefore, the price level
change does not shift the SRAS.
b. Government spending: While government spending affects aggregate demand, it
does not directly shift the SRAS curve. Government spending changes the
aggregate demand curve, not the supply curve.
c. The cost of all inputs: Changes in the cost of inputs (e.g., wages, raw materials)
directly affect production costs and with it, can cause shift of SRAS. An increase
in input costs would cause the SRAS curve to shift to the left (decreasing supply),
while a decrease in input costs would shift the SRAS curve to the right (increasing
supply).
4. Changes in price levels, increase or decrease, affect many elements of the AS-AD model,
but they do not affect the LRAS. Let us see why:
a. Inflationary expectations: These are forward-looking and based on long-term
factors, including monetary policy and historical inflation rates. They do not
necessarily change with short-term fluctuations in the price level.
b. Aggregate quantity demanded: According to the aggregate demand curve, a
decrease in the price level generally leads to an increase in the aggregate
quantity demanded, as lower prices make goods and services more affordable.
c. Long-run aggregate supply (LRAS): The LRAS curve is vertical and represents the
economy's potential output at full employment. It is determined by factors like
technology, capital, and labor, and is not affected by changes in the price level in
the short run.
d. Nominal wages: In the short run, nominal wages are often sticky due to contracts
and wage agreements, so they might not immediately adjust to changes in the
price level. However, over time, nominal wages may adjust to reflect changes in
inflation and the price level.
 e. Nominal output: Nominal output (or nominal GDP) is calculated based on current
prices. If the price level decreases, nominal output typically decreases as well,
assuming the quantity of goods and services produced remains constant.

5. According to the graph, we can analyze the effects of shifts in the aggregate demand
(AD) and aggregate supply (AS) curves on output (gross domestic product, GDP):

a. A rightward shift of the aggregate demand curve: This would increase output as
the economy moves to a higher level of GDP at a higher price level.
b. A leftward shift of the aggregate demand curve: This would decrease output as
the economy moves to a lower level of GDP at a lower price level.
c. A rightward shift of the aggregate supply curve: This would increase output as
the economy moves to a higher level of GDP at a lower price level.
d. A leftward shift of the aggregate supply curve: This would decrease output as
the economy moves to a lower level of GDP at a higher price level.
6. What happens to AD-AS model during a contractory shock?
A contractionary supply shock typically means an adverse event that reduces the
aggregate supply in the economy. This could be due to factors such as increased
production costs, natural disasters, or geopolitical events that disrupt supply chains.
 The effects of a contractionary supply shock are generally characterized by: A leftward
shift in the aggregate supply curve: This leads to higher prices (inflation) and lower
output. Look at the graph above, the new green AS curve signifies diminished supply due
to a contractor shock. Let us see what are likely scenarios when a contractory supply
shock happens:

a. An increase in aggregate demand: This is not a direct result of a contractionary

supply shock. The shock affects supply, not demand.
b. An increase in national income: This is unlikely because a contractionary supply
shock reduces output and income.
c. An increase in gross domestic product: This is also unlikely because the supply
shock reduces the overall output.
d. A decrease in the general price level: This is contrary to what usually happens;
the general price level would typically increase due to the reduced supply.
e. A decrease in employment: This is a likely outcome. With reduced output,
businesses may cut back on production and, consequently, on employment.

7. What are automatic adjustment mechanisms and what are the likely scenarios when
they are activated?
The automatic adjustment mechanism in the economy works to bring the economy
back to its potential GDP (long-run equilibrium) when there are deviations from it.
There are two main scenarios to consider:
a. When Current Real GDP is Above Potential GDP In this scenario, the economy is
producing more than its sustainable capacity, leading to upward pressure on
prices and wages.
i. Higher demand for labor: Businesses need more labor to sustain the
higher production levels.
ii. Increase in nominal wages: The demand for labor drives wages up as
firms compete for workers.
iii. Increase in production costs: Higher wages lead to increased production
costs.
iv. Leftward shift in SRAS: The increase in production costs causes the SRAS
curve to shift to the left.
v. Result of the mechanism: The higher price level reduces aggregate
demand, and the economy moves back to potential GDP.
Summary: Current GDP higher than potential GDP (expansion)=Nominal wages rise, shifting
the short-run aggregate supply curve to the left.
 b. When Current Real GDP is Below Potential GDP: In this scenario, the economy is
producing less than its sustainable capacity, leading to downward pressure on
prices and wages:
i. Lower demand for labor: Businesses need less labor due to lower
production levels.
ii. Decrease in nominal wages: The reduced demand for labor drives wages
down.
iii. Decrease in production costs: Lower wages lead to decreased production
costs.
iv. Rightward shift in SRAS: The decrease in production costs causes the SRAS
curve to shift to the right.
v. Result: The lower price level increases aggregate demand, and the
economy moves back to potential GDP.
Summary: Current GDP lower than potential GDP (recession)=Nominal wages fall, shifting the
short-run aggregate supply curve to the right.

Let’s see what we mean by deviations in the current GDP and why interventions are needed to
align them with potential GDP:
In the context of the automatic adjustment mechanism, a deviation refers to a situation where
the current real GDP differs from the potential GDP (also known as the natural level of output
or full-employment output). Potential GDP is the level of output the economy can produce
when operating at full capacity, with all resources (labor, capital, etc.) fully employed.
A. Positive Deviation (Overheating): This occurs when current real GDP is above potential
GDP. The economy is producing more than its sustainable capacity.
a. Indicators: High demand for goods and services, labor shortages, upward
pressure on wages and prices, and low unemployment rates.
b. Example: An economic boom where consumer spending and business
investment are very high, leading to production beyond sustainable levels.

B. Negative Deviation (Recessionary Gap): This occurs when current real GDP is below
potential GDP. The economy is producing less than its sustainable capacity.
a. Indicators: High unemployment rates, excess capacity in production, downward
pressure on wages and prices, and low demand for goods and services.
b. Example: An economic recession where consumer spending and business
investment are low, leading to underutilization of resources.
Two scenarios are not included in the automatic adjustment mechanisms: the supply shocks
and the governmental (monetary and fiscal policies). Supply shocks can be unintentional and
result of chance; governmental policies are very deliberate and planned and do not happen
automatically. Let’s see how they change the curve:
 Supply Shocks: Sudden changes in the availability of resources or technology can also
impact the SRAS curve. Positive supply shocks (e.g., technological advancements) shift
the SRAS to the right, while negative supply shocks (e.g., natural disasters) shift it to the
left.
 Monetary and Fiscal Policy: These are active stabilization policies that can speed up the
adjustment process, but they are not part of the automatic mechanism. For instance, an
expansionary fiscal policy (e.g., increased government spending) can increase aggregate
demand, while contractionary policy (e.g., tax hikes) can reduce it.

8. Expansionary and contractory policies

Monetary policy primarily controls the supply of money and interest rates, while fiscal policy
impacts the economy through government spending and taxation:
 Monetary Policy: This is managed by a country’s central bank (like the Federal
Reserve in the U.S.) and focuses on regulating the amount of money in circulation
and interest rates. The goal is to control inflation, stabilize the currency, and achieve
sustainable economic growth.
 Fiscal Policy: This is managed by the government and involves changes in
government spending and taxation. Fiscal policy influences the overall level of
demand in the economy and can affect the purchasing power of money by
influencing employment levels and economic growth.
Both of these policies can expand or shrink the economy, depending on which stage of the
business cycle it is. They are not without shortcomings, and governments usually use a
combination of policies to regulate the economy
Let’s see the effects of such a policy and on which part of the economy it will have an influence.
A decrease of taxes will be considered an expansionary fiscal policy and these are likely
scenarios when a tax decrease is employed in an economy:
a. Nominal gross domestic product (GDP): A decrease in taxes increases
disposable income for consumers and businesses. This typically leads to higher
consumer spending and business investment, which increases aggregate
demand and, consequently, nominal GDP. This is a direct and expected result of
tax cuts.
b. Unemployment: Lower taxes can stimulate economic activity and growth, which
may reduce unemployment. However, this is not a guaranteed outcome in the
short run, as it depends on other factors like labor market flexibility and
business response.
c. Marginal propensity to save (MPS): The marginal propensity to save is the
fraction of additional income that is saved rather than spent. Tax cuts increase
disposable income. The outcome may be the opposite, meaning more people will
 spend instead of save; however, the effect on MPS depends on individual
preferences and economic conditions. There is no necessary or direct
relationship between tax cuts and an increase in MPS.
d. Money supply: The money supply is controlled by monetary policy rather than
fiscal policy. A decrease in taxes affects aggregate demand but does not directly
alter the money supply.
9. Analyze image:

10. The short-run aggregate supply curve would be vertical if

11. 4MA31
12. nominal wages adjust immediately to changes in the price level
13. nominal wages adjust slowly when there is unemployment
14. both nominal wages and prices adjust slowly to changes in aggregate demand
15. the spending multiplier is very low
16. investment demand is very responsive to changes in interest rates