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### Study unit 8

AD/AS FRAMEWORK

STUDY OBJECTIVES

- Use aggregate demand and supply curves to analyse monetary and fiscal policies and supply shocks
- Monetary transmission mechanism
- Use AD-AS model to explain the policy dilemma in an open economy

AGGREGATE DEMAND POLICY

- AD shifts if there is a change in total expenditure.
- If A (TE) increase AD
- If A(TE) decrease AD

- Expansionary fiscal policy will shift AD to the right.
- Government Expenditure increases
- Taxes decreases

- Expansionary monetary policy will shift AD curve to right.
- Repo rate (interest rates decreases
- Cash reserves decreases – Loans increase
- Securities are bought back through open market transactions.

MONETARY TRANSMISSION MECHANISM POLICY

- Changes in the monetary sector are transmitted to the real sector through transmission mechanism.
- Real sector refers to the goods market, the factor market, production, income investment, imports, exports and consumption.
- The demand for money shows an inverse relationship with interest rates

KEYNESIAN TRANSMISSION MECHANISM POLICY

- Supply for money is vertical or independent of the interest rate.
- Investment is inverse related to interest rates.
- What happens if there are changes in the money market?
- SARB reduces interest rates.

EQUILIBRIUM IN THE MONEY MARKET POLICY

i

MS1

Interest rate decreases

Cash reserves decreases

SARB buys back securities through open market transactions

MS2

MD

Quantity of money

KEYNESIAN TRANSMISSION MECHANISM POLICY

- Interest rates decrease MS i I AS production employment Income AD-curve
- The demand and supply for money determines the interest rate level, which is an important determinant of investment. Investment is an important determinant of aggregate spending, which determines production or income (Y).
- Vital links in the transmission mechanism is:
- interest rates is affected by the change in money supply
- interest rates affects investment spending
- Investment spending influences autonomous expenditure and AD-curve

POLICY DILEMA IN AN OPEN ECONOMY POLICY

- Exports is autonomous
- Imports is positively related to income.
- If exports exceeds imports - surplus on current account
- If exports is smaller than imports - deficit on current account.
- If open economy is experiencing unemployment, then the introduction of expansionary policy will solve unemployment problem, but increase the deficit on the current account.
- In order to apply stimulative policies, the deficit on current account must be financed by an inflow of funds on the capital (financial) account of balance of payments.

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