ECON 1202 Lecture Notes - Lecture 23: Aggregate Demand, Aggregate Supply, Demand Curve

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ECON 1202 Lecture 22: Aggregate Demand and Supply

ECON 1202 Lecture Notes - Lecture 23: Aggregate Demand, Aggregate Supply, Demand Curve

ECON 1202 Lecture Notes - Lecture 24: Aggregate Demand, Aggregate Supply, Nominal Rigidity

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Y = c + i + g + nx: total income = total expenditure, total expenditure = total or aggregate demand (ad, ad = c + i + g + nx. Already have been talking about ad: know that real gdp = consumption + investment + government spending + net exports (consumption/expenditures, total income = total expenditures. What causes it to shift/change: changes in consumption, investment, government purchases, net exports. Graph of ad is similar to demand schedule: increase in ad = shifts to right, decrease in ad = shifts to left. What causes consumption/investment/gov"t expenditures to change: income, people expect higher income = increase expenditures because higher income, wealth, expectation, tax, exchange rate, scal policy, foreign income, monetary policy. Housing boom in 2002: decline in aggregate demand, what is happening: change in consumption. When aggregate collapsed what did feds do: zero interest rates, goal was to shift aggregate demand back, borrow more, spend more.

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MBA502, Economics for Business

Apply and Discover 7.2

You are responsible for economic policymaking in your country. Your desire is to eliminate inflation, keeping prices absolutely stable at P = 100, no matter what happens to output. Currently, the economy is in equilibrium at Q = 3200 (where Q = potential GDP) and P = 100. You can use monetary and fiscal policies to affect aggregate demand but you cannot affect aggregate supply in the short run. How would you respond to the following scenarios?

Explain and illustrate how each of these events would affect aggregate demand, aggregate supply, and prices, then explain how you would respond with economic policies.

1. A surprise increase in investment spending

In the short run, when investment spending increases, it results in an increase in Aggregate Demand (AD), which in turn pushes up both GPD and the price index.

To counterbalance this development, government might pursue contractionary fiscal policy by increasing taxes (to reduce consumption) or decreasing its own investment and spending so that the AD curve shifts back to its original position. Alternatively, the government can pursue contractionary monetary policy by reducing money supply and increasing interest rate to discourage economic activity.

2. Catastrophic floods that cause a sharp food price increase

In this case, sharp food shortages and consequent price increases cause a shock-type adjustment of the aggregate supply curve (it shift up and to the left). The result is a lower GDP and a higher price level.

The government cannot do anything to adjust AS in the short run. However, if the goal is to maintain the price level constant, the government can decide to do something to decrease the aggregate demand to force prices to come down, though it will be accompanies by another contraction in GDP and so it would not be a smart thing to do.

To cause AD to decrease, the government, similar to example above, can pursue fiscal policy (increase taxes, decrease spending) or monetary policy (reduce supply of money to the economy and thus increase interest rates).

3. A productivity decline that reduces potential output

In this case, AS shifts to the left, as was the case in example 2. As a result, price levels go up, as the same amount of money is chasing the reduced amount of goods and services, and GDP declines.

Government remedies here would be centered about causing AD to decrease through contractionary fiscal (higher taxes, lower spending) or monetary (reduce money supply and increase interest rates) policy. Again, this decision reduces inflation but at expense of GDP, as real output shrinks further.

4. A deep depression in East Asia that causes a sharp decrease in net exports to the United States

A decrease in exports of goods to from the United States to Asia will mean that the aggregate demand (which includes net exports

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In the AD-AS model, stagflation does not persist, because the working of the self-correcting mechanism of the economy _____ the level of output and _____ the price level until the economy eventually returns to a long-run equilibrium state, where actual output _____ potential output.

	decreases; decreases; falls short of
	increases; decreases; equals
	decreases; increases; exceeds
	decreases; increases; equals
	increases; decreases; exceeds

The LRAS curve is drawn as a vertical line at potential output (Y*) to indicate that

	Y* is independent of the price level and that actual output Y > Y* in the long run
	Y* equals actual output (Y) in the long run
	Y* is independent of the price level and that actual output Y = Y* in the long run
	Y* is independent of the price level
	Y* is independent of the price level and that actual output Y < Y* in the long run

Stagflation arises in the context of the AD-AS model when some external factor causes

	the LRAS curve to shift to the right
	the AD curve to shift leftwards
	the SRAS curve to shift downwards
	the SRAS curve to shift upwards
	the AD curve to shift rightwards

If the SRAS curve is positively sloped, then a decrease in the demand for Canadian-made goods in Europe will lead to _____ in the price level, in the short run.

	either an increase or a decrease
	no change
	an increase
	a decrease
	an initial increase, and then a decrease

Which of the following will shift the aggregate demand curve to the right?

	Consumers become pessimistic about the future
	A new technology is developed that will increase profits
	Income taxes are raised
	Foreign economies fall into recession, reducing their demand for domestic exports
	The government reduces purchases to balance the budget

Suppose a stock market crash decreases the stock of household wealth and therefore causes autonomous consumption to fall. Which of the following is the likely result?

	A leftward shift the AD curve
	There will be no movement of the AD curve
	A movement down the AD curve
	A movement up the AD curve
	A rightward of the shift the AD curve

An economy is characterized by the AD equation P = 200 ? 0.02Y, SRAS equation P = 100 and LRAS equation Y* = 5000. In the absence of any change in policy or exogenous shocks, this economy will achieve a long-run price level of

	100
	110
	120
	90
	105

The AD-AS model depicts a self-correcting economy. This means that the price level in the model adjusts automatically in response to a(n) _____ gap, so as to eliminate the _____ gap in the long run, without requiring any help from government policies.

	recessionary; recessionary
	recessionary; expansionary
	expansionary; expansionary
	output; output
	expansionary; recessionary

The aggregate demand curve shows

	the amount of planned aggregate expenditure (and output) at the current price level
	the amount of planned aggregate expenditure (and output) at an average price level
	the amount of planned aggregate expenditure (and output) at a constant price level
	the amount of planned aggregate expenditure (and output) at various price levels
	the amount of planned aggregate expenditure (and output) at last year's price level

Consider an economy initially at long-run equilibrium with output (Y) equal to potential output (Y*). If the SRAS is positively sloped, then a shift to the right of the AD curve will lead to _____ in the price level, in the short run. In the long run, the SRAS curve will shift to the _____ and the equilibrium will be at __________.

	an increase; left; Y = Y*
	a decrease; right; Y > Y*
	an increase; right; Y = Y*
	a decrease; left; Y > Y*
	no change; left; Y = Y*

Here is the question and the answers. But I need an explanation of WHY the answer is what it is. Any answers that don't answer why for each one will only get 1 star.

What effects would each of the following have on aggregate demand or aggregate supply? In each case use a diagram to show the expected effects on the equilibrium price level and level of real output. Assume that all other things remain constant.

a. A widespread fear of depression on the part of consumers.

b. A $2 increase in the excise tax on a pack of cigarettes.

c. A reduction in interest rates at each price level.

d. A major increase in Federal spending for health care.

e. The expectation of rapid inflation.

f. The complete disintegration of OPEC, causing oil prices to fall by one-half.

g. A 10 percent reduction in personal income tax rates.

h. A sizable increase in labor productivity (with no change in nominal wages).

i. A 12 percent increase in nominal wages (with no change in productivity).

j. Depreciation in the international value of the dollar.

ANSWERS

(a) AD curve left, output down and price level down (assuming no ratchet effect).

(b) AS curve left, output down and price level up.

(d) AD curve right, output and price level up (any real improvements in health care resulting from the spending would eventually increase productivity and shift AS right).

(e) AD curve right, output and price level up.

(f) AS curve right, output up and price level down.

(g) AD curve right, output and price level up.

(h) AS curve right, output up and price level down.

(i) AS curve left, output down and price level up.

(j) AD curve right (increased net exports); AS curve left (higher input prices)

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ECON 1202 Lecture Notes - Lecture 23: Aggregate Demand, Aggregate Supply, Demand Curve

ECON 1202 Lecture 22: Aggregate Demand and Supply

ECON 1202 Lecture Notes - Lecture 23: Aggregate Demand, Aggregate Supply, Demand Curve

ECON 1202 Lecture Notes - Lecture 24: Aggregate Demand, Aggregate Supply, Nominal Rigidity

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