Tutorial 6 (AD & AS) (Answers are provided as a guide but not limited to the

following)

Question 1

Explain what the aggregate supply curve (AS) represents and why it is upward sloping.

Indicative answer:

The AS curve illustrates the effects of output on the price level and is derived from the
behavior of wages and prices as determined by wage setting and price setting behavior. An
increase in output (Y) requires firms to increase employment (N). An increase in employment
(N) causes a reduction in the unemployment rate (U). As the unemployment rate decreases,
workers have more bargaining power so the nominal wage will rise. The increase in the nominal
wage will cause an increase in firms' costs. As firms' costs rise, they will increase the prices
as determined by price setting behavior. So, an increase in output (Y) causes an increase in
price (P). This explains why the AS curve is positive upward sloping.
Question 2

Explain what the aggregate demand curve (AD) represents and why it is negative
downward sloping.

Indicative answer:

The AD captures the effects of the price level on output. Alternatively, the AD curve
represents the combinations of P and Y that maintain equilibrium in the goods and financial
markets.

The negative downward sloping AS curve can be explained by three effects of Wealth Effect,
Interest Rate Effect and Exchange Rate Effect. Assuming price (P) increases causing value
of money to decrease and demand for goods decreases, hence decreases output. This is known
as Wealth Effect

Price increase also cause the real money supply to decrease (LM curve shift upward) causing
an increase in the interest rate. The increase in the interest rate causes decrease in investment,
decrease in demand, and decrease in production / output. This is known as Interest Rate
Effect.

In an open economy, an increase in domestic interest rate will cause inflow of funds from
abroad. This will cause increase in demand for domestic currency driving it to appreciate. An
appreciation of domestic currency will make domestic goods to be relatively more expensive
compared to good abroad, thus reducing export, hence decreases output. This is known as
Exchange Rate Effect. Hence, this explains why a price increase (decrease) reduces
(increases) output level of an economy.

So, the increase in price (P) causes decrease in output (Y), thus AD curve is negatively
downward sloping, showing an inverse relationship between price and output.
Question 3

Explain what effect a reduction in the money supply (monetary contraction) has on the
aggregate demand (AD) curve.

Indicative answer:

A reduction in Ms causes the LM curve to shift up and the interest rate to rise. As the interest
rate rises, investment and demand will decrease. Firms will respond to the drop in demand by
decreasing production. This implies that the drop in Ms (which is exogenously determined by
Central Bank) will cause the AD curve to shift to downward left.

Question 4

Explain how changes in each of the following variables affects the aggregate price level
(P):

(a) reduction in the expected price level (Pe);

Indicative answer:

Given a drop in the expected price level, future real wage is expected to rise. Wage setters have
no reason to seek higher nominal wages, hence willing to accept a lower nominal wage when
firms reduce nominal wage as expected lower future price level would squeeze their margin.
As nominal wage lowers, firms' costs fall likewise. Since firms' costs fall, they can set their
price lower (as a markup over the now lower W). So, price level will fall as the expected price
falls and shift AS curve downward right (by moving along a negatively downward sloping AD
curve), expanding output level.

(b) reduction in employment (N);

Indicative answer:

As the employment reduces (or unemployment increases), workers have less bargaining power
so the nominal wage will fall., hence lower real wage for a given price level in short run. AD
curve will shift downward left and both price level and output reduce following lower real
wage (due to lower nominal wage). Reduction in output increases unemployment (as per
Okun’s Law).

The lower nominal wage reduces firms' costs. For a given mark up (m), price level likewise
decreases as determined by price setting behavior P = (1+ m) W, hence real wage will decrease,
causing PS relation to shift downward by moving along the WS relation and increases
unemployment level.

(c) reduction in markup (m)

Indicative answer:

A reduction in the markup means that firms are setting prices lower for a given cost, hence a
lower profit. So, the decrease in the markup will cause a price level to fall, thus increase real
wage. Rise in real wage increases demand. The PS relation will shift upward by moving along
the WS relation and reduces unemployment. This is because as demand increases, output
likewise increase leads to more hiring thus reduces unemployment.

(d) reduction in unemployment benefits (z).

Indicative answer:

A reduction in unemployment benefits will cause the WS curve to shift down and cause wage
setters to seek lower nominal wages. As nominal wage W falls, firms' costs fall. When firms'
costs fall, they can set their prices lower (as a markup over the now lower W). As such, price
level will fall as unemployment benefits fall.
Question 5

Suppose the economy is currently operating at a point where output is greater than the
natural level of output (Y > Yn). Given this information, is the actual price level (P) equal
to the expected price level (Pe) at the current level of output? Explain.

Indicative answer:

When Y exceeds the natural output level (Yn), we know that Y must have risen above the
natural level (economy is propelling in an expansion stage of business cycle). However, when
output is operating at the natural output level (potential GDP), we know that the actual and
expected price level are equal (P = Pe).

When output level Y rises above the natural level, there will be pressure for the price level to
rise because actual P is greater than the expected price level ie Pe (P > Pe). As price level P
rises, it rises above the expected price level Pe, shifting AS curve upward left (see diagram
below).