Aggregate Demand and Aggregate Supply

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Economics II
Written Assignment

Aggregate Demand and Aggregate Supply

11. For each of following events, explain the short-run and the long-run effects on the output and the price level, assuming policymakers take no action.

(a) The stock market declines sharply, reducing consumers’ wealth.

AS1
AS2
AD1
AD2
Y2
Y1
P1
P2
P3
LRAS
A
B
C
P
AD-AS diagram
Output
0

Since the stock market declines sharply, the people’ wealth are being affected. In short run, it leads to a fall in aggregate demand which would shift aggregate-demand curve from AD1 to AD2. The economy is reached from point A to point B because the output level and the price level would fall from Y1 to Y2 and falls from P1 to P2 respectively.

Over time, the price level would be adjusted, so the short run aggregate supply curve would shift rightward from AS1 to AS2. As a result, the output level would return to the natural rate of output Y1 and the price level would fall from P2 to P3. And the economy would be reached at point C which is the interaction of new-aggregate demand curve and long-run aggregate-supply curve.

(b) The federal government increases spending on national defense.

AS2
AS1
AD2
AD1
Y2
Y1
P3
P2
P1
LRAS
C
B
A
P
AD-AS diagram
Output
0

In short run, the federal government increases spending on national defense means that an increase in government purchases. Thus, the aggregate-demand curve would shift rightward from AD1 to AD2. With the both rising output and price level, the economy would be reached from point A to point B.

In long run, as the price level has adjusted, the short run aggregate supply curve shift leftward from AS1 to AS2 to restore the equilibrium at point C. And the price level would rise to P3 and the output would return to the natural rate of output Y1.

(c) A technological improvement raises productivity
AS1
AS2
AD
Y2
Y1
P2
P1
LRAS
B
A
P
AD-AS diagram
Output
0
LRAS2

Since there is an improvement in technology, it raises the productivity. As a result, both the short-run and long-run aggregate supply curve would shift rightward from AS1 to AS2 and from LRAS1 to LRAS2 respectively. The economy would then move from point A to point B as the price level decrease from P1 to P2 and the output increase from Y1 to Y2.

(d) A recession overseas causes foreigners to buy fewer U.S. goods.

AS1
AS2
AD2
Y2
Y1
P2
P1
LRAS
B
A
P
AD-AS diagram
Output
0
LRAS2
AD1
C
P3

When there is a recession overseas, it causes the foreigners to buy less U.S. goods and so decrease the net exports. As a result, the aggregate demand curve would shift to the left. With the declining output and price level, the economy would be reached from point A to point B.

Over time, the short-run aggregate-supply curve would shift rightward and thus the economy would move to point C. And, the price level would fall and the output would return back to the natural rate of output Y1.

13. Suppose firms become very optimistic about future business conditions and invest heavily in new capital equipment.

(a) Draw an aggregate-demand / aggregate-supply diagram to show the short-run effect of this optimism on the economy. Label the new levels of prices and real output. Explain in words why the aggregate quantity of output supplies changes.

AS1
AD2
AD1
Y1
Y2
P1
P2
A
B
P
Output
0

If the firms are optimistic about the future business conditions and invest heavily in new capital equipment, it tends to raise the investment and so is the aggregate demand which shift from AD1 to AD2. The economy is reached at point B now. And the price level and output would rise to P2 and Y2 respectively.

Besides, as the price level has risen, the aggregate quantity of output would increase due to the misperceptions of the price level, sticky wages and sticky prices.

(b) Now use the diagram from part (a) to show the new long-run equilibrium of the economy....
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