Quiz 10: Dynamic Change, Economic Fluctuations, and the Ad--As Model

Business

(a) As people are expecting a recession in future time period they will curtail their current expenditure so as to have necessary resources to tide over the difficult time in future. This reduction in current expenditure due to fear of recession will bring a decline in aggregate demand. (b) As people are expecting an increase in price level in future, they will be induced to spend more during the current period and would more goods and services as they feel that their purchasing power will decline in future due to expected inflation. More spending in current time period due to expectations of high rate of inflation in future will bring an increase in aggregate demand in the current time period. (c) With rapid growth of real income in Canada and Western Europe, demand for both domestically produced and imported goods and services will increase. As United States also exports goods to these two regions, demand for U.S. goods will also increase and exports of U.S. will rise resulting an increase in net exports. Net exports are a component of aggregate demand. So, increase in net exports implies an increase in aggregate demand. So, rapid growth of real income in Canada and Western Europe will increase the aggregate demand in United States. (d) Reduction in real interest rates will reduce the cost of borrowing. This reduction in cost of borrowing will make it cheaper for households to buy major durable goods now than in future and thus they will increase their consumption spending. Lower real interest rates will also stimulate the investment spending. Consumption and investment spending being the component of aggregate demand, increase in these components means increase in aggregate demand as well. (e) A higher price level will reduce the purchasing power of the general public in United States resulting in decrease in their consumption expenditure and thereby decreasing the aggregate demand as well.

(a) This factor will increase the production cost and thus squeeze the profit margin. This squeezing of profit margin will compel the firms to reduce output. Reduction in output will result in fall in U.S. aggregate supply in the short-run. (b) As we know that supply shocks impact the current output of the economy. Supply shocks can be both favorable as well as unfavorable. Favorable supply shocks such as favorable weather conditions or fall in price of imported resources etc. increases the current supply whereas unfavorable supply shocks such as natural disasters, severe weather conditions, rise in price of imported resources etc. reduces the current supply. The given factor being an unfavorable supply shock will reduce the U.S. aggregate supply in the short-run. (c) When sellers anticipate an increase in rate of inflation in the future, they tend to hold back the supply so as to be able to sell the goods at higher price in future. Secondly, as they have produced these goods in earlier time period that is at lower cost, selling them at higher price in future will increase their profit as well. Both these factors induce the producers to cut back the supply and thus U.S. aggregate supply in short run will decline. (d) As we know that supply shocks impact the current output of the economy. Supply shocks can be both favorable as well as unfavorable. Favorable supply shocks such as favorable weather conditions or fall in price of imported resources etc. increases the current supply whereas unfavorable supply shocks such as natural disasters, severe weather conditions, rise in price of imported resources etc. reduces the current supply. The given factor being a favorable supply shock will raise the U.S. aggregate supply in the short-run. (e) As we know that supply shocks impact the current output of the economy. Supply shocks can be both favorable as well as unfavorable. Favorable supply shocks such as favorable weather conditions or fall in price of imported resources etc. increases the current supply whereas unfavorable supply shocks such as natural disasters, severe weather conditions, rise in price of imported resources etc. reduces the current supply. The given factor being an unfavorable supply shock will reduce the U.S. aggregate supply in the short-run.

The difference between the production possibilities constraint and the long-run aggregate supply curve is that while production possibilities constraint shows various alternative production possibilities facing an economy, Long-run aggregate supply curve shows the rate of sustainable output that an economy can maintain at maximum. Changes in conditions that move the production possibilities curve would also move the LRAS curve. For example, if improvement in technology enhances the production possibilities of an economy and thus move the production possibility curve to the right then same change will also move the LRAS curve to the right as well because improvement in technology will result in more output and thus increase the rate of sustainable output that an economy can produce which means a rightward shift in LRAS curve. Improvements in computer technology expand the production capacity of an economy and also enhance the productivity as well. This expansion in production capacity and enhancement of productivity will increase the production possibilities of the economy and thus shift the long run aggregate supply curve to the right.

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