Quiz 9: An Introduction to Basic Macroeconomic Markets

Business

The demand curve for any individual good shows the inverse relationship between price and quantity demanded of the good. That is when price fall the quantity demanded of that particular good rises. The aggregate demand curve is the summation of all individual demands in all the sectors in the economy, viz., consumer, investment, government and foreign. It represents the demand for all the final goods and services produced within an economy during a given period of time. Thus, aggregate demand represents the inverse relationship between level of price and the quantity of final goods and service demanded in an economy during a given period of time. The demand for final goods and services in the economy is inversely related to price level in the economy because of three different reasons: 1. A fall in prices increases demand for final goods and service by increasing the value of currency. As price falls people will need less money to buy consumption goods. They will have more money hand than they would have without fall in prices. This enables them to spend some of this extra money in consumption and the demand for final goods and services increases in the economy. 2. A fall in prices increases demand for final goods and service by increasing the value of currency. As price falls people will need less money to buy consumption goods. They will have more money hand than they would have without fall in prices. People will saves some of the money and supply of funds in loanable funds market increases. The increase in funds decreases the price of funds or the interest rate. The fall in interest rate stimulates investment demand and aggregate demand increases. 3. A fall in prices increases demand for final goods and service by increasing the value of currency. As price falls people will need less money to buy consumption goods. They will have more money hand than they would have without fall in prices. This fall in overall prices will make domestic goods cheap and import decreases. The cheap domestic goods also increases export as foreigners increase their consumption cheap domestic goods. The increase in export and decrease in import increases net export and aggregate demand increases. The demand curve for specific goods shows the price and quantity demanded of that particular good. The fall in price of a particular good makes it cheap relative to its close substitute and people find it profitable to buy the good. Thus, quantity demanded of the good increases. However, for the aggregate demand a fall in prices means fall in overall price making every goods and services in the economy cheaper. The inverse relationship in this case stems from the fact that the fall in prices makes consumption, investment and domestic goods cheaper and increasing the aggregate demand as a whole.

The aggregate supply curve depicts the positive relationship between quantity supplied and the aggregate price level in the economy. There are two different supply curves: long run supply curve and short run supply curve. The short run supply curve given the quantity the domestic firms will supply at any given level of prices. The long run supply curve gives the potential output of the economy that can be produced given the efficient use of all its resources. The production possibility curve gives the combination of all goods and services that can be produced by efficiently using all the resources available to an economy. This gives the potential output mix an economy can produce in the long run. On the other hand the long run aggregate supply curve gives the value of all final goods and services that can be produced in the long run. In the long run all the prices including wages are flexible to adjust according to changing prices and competitive forces ensures the efficient use of resources. Thus, in the long run economy produces its potential output. This is fixed by the availability of resources. The country cannot produce beyond its potential output in the long run unless the factor which affects the potential output changes. In this way the long run aggregate supply curve and the production possibility curve is synonymous. The long run aggregate supply curve gives the value of all final goods and services that can be produced in the long run. In the long run all the prices including wages are flexible to adjust according to changing prices and competitive forces ensures the efficient use of resources. Thus, in the long run economy produces its potential output. This is fixed by the availability of resources. The country cannot produce beyond its potential output in the long run unless the factor which affects the potential output changes. Therefore, a change in prices cannot change the ability to produce goods and services and the long run output is fixed irrespective of prices. Hence, the long run supply curve is vertical straight line giving the fact that whatever the price might be the supply of goods and services will be fixed at potential level.

The aggregate supply curve depicts the positive relationship between quantity supplied and the aggregate price level in the economy. There are two different supply curves: long run supply curve and short run supply curve. The short run supply curve given the quantity the domestic firms will supply at any given level of prices. The long run supply curve gives the potential output of the economy that can be produced given the efficient use of all its resources. In the short run the prices which are set through long term contract could not be altered. Thus, wages, interest rate on loans, and other resources costs are fixed. Then an unanticipated rise in price due to stronger demand will increase the profit of the producers'. The producer will have higher incentive to expand production and the output of the economy increases. Thus, in the short run there exists a positive relationship between level of prices and quantity supplied that makes the supply curve slopped upward to the right. If the prices of both the resources and goods and services increase proportionately the profit level of producers' will remain unchanged. As the level of profit provide the strong incentive to expand production, an unchanged profit level will leave the production level unchanged.

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