The AD/AS model is useful in predicting the effects of various shocks and policy
ID: 1214103 • Letter: T
Question
The AD/AS model is useful in predicting the effects of various shocks and policy changes on an economy. The model is based on goods and services being exchanged in well-functioning markets. In general, however, markets are not always perfect. Consider how the model would change as a result of market imperfections. (Hint: Can the AS/LRAS shift when there are governmental controls?)
A- How would the AD/AS model change if input prices, such as wages and raw material prices, were set by the government rather than in markets?
B- If the government sets input prices, what long-run effect would this have?
Explanation / Answer
The AD–AS or aggregate demand–aggregate supply model is a macroeconomic model that explains price level and output through the relationship of aggregate demand and aggregate supply. The AD-AS framework divides the economy into two parts – the ‘demand side’ and the ‘supply side’. The ‘demand side’ typically examines factors relating to the demand for goods and the demand and supply of assets. The ‘supply side’ typically examines factors relating to output and pricing decisions of producers, and factor markets. The framework ensures that neither demand nor supply side factors are overlooked in the analysis and that macroeconomic outcomes depend on the interaction between the different markets. Now if the government sets the prices of the wages and prices for raw materials, the aggregate demand curve will shift. If wage prices are increased that means engagement of labours will become expensive and hence the demand will decrease and the aggregate demand curve will shift to the right. Further, changes in the general price level affect the real value or purchasing power of money balances and monetary assets with fixed nominal values (such as bank deposits, bonds, etc.) held by the people. With the rise in the general price level, the real value of these monetary assets will fall making people feel poorer than before. This induces them to consume less and therefore lead to the decline in quantity of output purchased by them. Conversely, if the price level falls, the real value of their monetary assets increases inducing them to buy more.
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.