Quiz 10: Dynamic Change, Economic Fluctuations, and the Ad--As Model
a. 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 aggregate demand in the economy changes due to • Changes in the real wealth of the consumer prompted the consumer to change their consumption and the aggregate demand in the economy changes. • Changes in real interest rate makes the investment and consumption goods cheaper or expensive. The consumers and producers change their demand for these goods according to this change. The cheaper investment and consumption goods due to fall in interest rate increases the aggregate demand. • Changes in expectation about the future state of the economy changes the aggregate demand of the economy. The increase in the optimism about the future state or future expansion in the economy prompted the consumer to buy goods and services that increases consumption demand. The optimism also prompted the producers to invest more as they will see expanding economy will lead to higher profit. The increase in both consumption and investment demand will increase the aggregate demand. • Changes in the expectation about the future price level will change aggregate demand. If the consumer and producer expect a higher price level in future they will tend to spend more on current period, increasing the aggregate demand. • A rise in income of the trading partners will tend to increase export and thus aggregate demand. • Changes in exchange rate influence the relative prices of the export and import. An appreciation of home currency will lead to cheaper imports and expensive export. This will decline export and increase import leading to fall in net export and aggregate demand. The increased fear of recession will make people pessimistic about the future of the economy. They will fear losing their jobs and producers will fear a loss from new venture. This will direct the consumer to cut back some of its consumption in current period and producers' will decrease their level of investment. The fall in both consumption and investment will decrease aggregate demand in the economy. b. The increased fear of inflation will lead to higher expectation about future prices. As the consumer and producer expect higher level of future prices they will increase their spending in current period. This increase in spending will boost current aggregate demand in the economy. c. Canada and Western Europe is the leading trade partner of US economy. A rise in income of the trading partner will increase the export of the economy. The rise in export will increase the net export and will boost current aggregate demand in the economy. d. A reduction in the real interest rate makes investment cheaper for the producers and consumption good bought in credit. This will increase the investment demand and consumption demand. The rise in investment and consumption will boost aggregate demand. e. A higher level of prices will make everything expensive in current period. This will make the level of prices to rise in the economy. A rise in general level of prices will make investment and consumption expensive in current period. This will prompt the producers to cut investment demand and consumers to cut current consumption. On the other hand this will make domestic goods expensive relative to foreign goods leading to decline in the net export. All of these factors will decrease the quantity of aggregate goods and service demanded in the economy. This will prove the inverse relationship between aggregate demand and current price level. Thus, a rise in price will decrease quantity demanded and will represents moving of the economy long the aggregate demand curve.
a. 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 factors that changes long run aggregate supply curve are • Changes in supply of resources. • Changes in the technology. • Changes in the efficient use of resources. The factors that changes the short run aggregate supply are • Changes in resource prices change the cost of production and aggregate supply changes accordingly. • Changes in expected rate of inflation changes the aggregate supply in the short run. If the producers' think that price will go up in future, they will simply hold back the supply in order to get higher prices in the next period. This will decrease the aggregate supply in the short run. Similarly, a decrease in expectation about future prices will increase short run supply. • The supply shocks, such as change in weather or change in price of the imported resources will change the supply in the short run. An increase in real wages will increase the cost of production. This will decrease the profit level of the producers for each level of prices. The aggregate supply will fall in the economy shifting the aggregate supply curve to the left. b. The freeze that destroys the orange trees represents the adverse supply shock that hit the economy. This will decrease the production of all products that requires oranges as an input. The fall in production in one industry will decrease the aggregate supply in the economy. c. The increase in the expected rate of inflation will make the producers' optimist about future prices. This prompted them to decrease the supply in the current period in order to get higher prices in the next. Thus, the aggregate demand falls in current period. d. Oil is an important imported resource of production. A fall in oil prices represents favorable supply shock. This decreases the cost of production and increases the supply in the short run. e. A heavy rainfall during the growing season tend to destroy the crops and represents adverse supply shock. The adverse supply shock tends to decrease short run aggregate supply.
The production possibility curve shifts outwards when there is improvement in technology or increase in the stock of capital, it means there is growth in the resources of the economy, as a result of which the aggregate supply in the long run will increase. It will shift the vertical long run aggregate supply (LRAS) curve to the right. An improvement in technology will increase the aggregate supply and shift the vertical aggregate supply curve to the right. Use diagram to show the shift in LRAS: Figure 10.3 Explain: The long run aggregate supply curve (LRAS) shifts to the right from LRAS1 to LRAS2, showing increase in aggregate supply due to increase in resources and improved technology. Improvement in computer technology reduce cost of doing commercial and business activities and also increase the production capacity of firms, which increases the production possibilities, and shifts the long run aggregate supply curve to the right. For example use of computers in the car assembly lines has increased the production of automobiles.