EC102
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Essay question 1
Discuss the mechanism through which the following events translate into demands shocks:
a) A war
b) An increase in interest rates
c) An increase in income taxes
Answer the following questions:
d) What is the aggregate demand curve and why is it downward sloping?
e) Why is the aggregate supply curve horizontal in the short run?
f) Use the AD-AS framework to illustrate the effects of an increase in desired consumption due to “animal spirits”
g) Use the AD-AS framework to illustrate the effects of an increase in interest rates
SOLUTIONS
Discuss the mechanism through which the following events translate into demands shocks
a) A war
SOLUTION: A war is the classic example of an exogenous increase in government expenditure. This increase in G makes the AD curve to shift to the right
b) An increase in interest rates
SOLUTION: An increase in interest rates makes consumption of durable goods and investment less appealing. C and I decrease. AD shifts to the left
c) An increase in income taxes
SOLUTION: Consumption depends on disposable income. Disposable income depends on taxes. The higher taxes, the lower the disposable income and the lower the consumption. Therefore the lower AD, for any price level. AD shifts to the left.
d) What is the aggregate demand curve and why is it downward sloping?
SOLUTION: The aggregate demand curve represents the relationship between the price level and the quantity of total output demanded (Yd). It is downward sloping because at high price level corresponds a high interest rate, and so low C and I. Consequently low Yd. At low price level, low interest rate, so high C and I, and high Yd.
e) Why is the aggregate supply curve horizontal in the short run?
SOLUTION: The aggregate supply is horizontal in the Short run because we assume it does not depend on the price level. At a given
Essay question 1
Discuss the mechanism through which the following events translate into demands shocks:
a) A war
b) An increase in interest rates
c) An increase in income taxes
Answer the following questions:
d) What is the aggregate demand curve and why is it downward sloping?
e) Why is the aggregate supply curve horizontal in the short run?
f) Use the AD-AS framework to illustrate the effects of an increase in desired consumption due to “animal spirits”
g) Use the AD-AS framework to illustrate the effects of an increase in interest rates
SOLUTIONS
Discuss the mechanism through which the following events translate into demands shocks
a) A war
SOLUTION: A war is the classic example of an exogenous increase in government expenditure. This increase in G makes the AD curve to shift to the right
b) An increase in interest rates
SOLUTION: An increase in interest rates makes consumption of durable goods and investment less appealing. C and I decrease. AD shifts to the left
c) An increase in income taxes
SOLUTION: Consumption depends on disposable income. Disposable income depends on taxes. The higher taxes, the lower the disposable income and the lower the consumption. Therefore the lower AD, for any price level. AD shifts to the left.
d) What is the aggregate demand curve and why is it downward sloping?
SOLUTION: The aggregate demand curve represents the relationship between the price level and the quantity of total output demanded (Yd). It is downward sloping because at high price level corresponds a high interest rate, and so low C and I. Consequently low Yd. At low price level, low interest rate, so high C and I, and high Yd.
e) Why is the aggregate supply curve horizontal in the short run?
SOLUTION: The aggregate supply is horizontal in the Short run because we assume it does not depend on the price level. At a given