Question

Answer all the following questions with an essay of not more than 300 words each:

A-What is an aggregate supply curve? Explain the circumstances under which the aggregate supply curve is horizontal, upward sloping, and a vertical straight line.

B-

Explain the short-run and long-run effects of the following events on output and price level with the AD-AS diagram:

a.

tax cuts

b.

money supply increases

c.

an increase in the price of key imported inputs

d.

a natural disaster that destroys a significant portion of production capacity

e.

a major technological innovation

Answer 1

Ans (A) Aggregate supply curve shows the relationship between price level and output level supplied by the firms. Note that, the output here is referred to all the goods and services produced in a country.

Upward Sloping Aggregate Supply Curve: The upward-sloping aggregate supply curve—also known as the short run aggregate supply curve—shows the positive relationship between price level and real GDP in the short run.The aggregate supply curve slopes up because when the price level for outputs increases while the price level of inputs remains fixed, the opportunity for additional profits encourages more production.

Vertical Aggregate Supply Curve: The curve shows the full employment level of GDP or long run aggregate supply curve. The AS is vertical in classical case where they assume that economy always works at full employment level, the prices and wages are flexible in the economy.

Horizontal Aggregate Supply Curve: The curve is horizontal in Keynesian case. As per Keynes, the prices and wages are not flexible but they are sticky in nature. There always exists some level of unemployment in the economy, all the resources are not fully utilised. That is why, the curve is horizontal.

Ans (B) .

A Tax Cut: It will increase the disposable income of individuals. As a result the aggregate demand rises and the the AD curve shift to right. The short run output level rises and exceeds long run output level. The price level also rises. This causes an inflationary gap in the economy. In the long run, aggregate demand will shift to its initial level because of inflationary pressure. The price and output level will return back to its long run equilibrium level.

Money Supply Increases: As money supply increases, interest rate falls, so the consumers will hold more money in hand and less in bonds. They will spend more. The consumer spending rises. Due to the decrease in interest rates, the investment also rises. Therefore, the aggregate demand in the economy rises and AD curve shift to the right. The short run output level rises and exceeds long run output level. The price level also rises. This causes an inflationary gap in the economy. In the long run, aggregate demand will shift to its initial level because of inflationary pressure. The price and output level will return back to its long run equilibrium level.

An increase in the price of key imported inputs: As the price of inputs rises, firms will produce less output. The short run aggregate supply curve shift to left, the short run aggregte supply decreases. As a result, price level rises and output level falls. This situation of rising prices and falling output is called as STAGFLATION, which is a combination of stagnant output and inflation. In the long run, due to the availability of substitutes or entry of other firms in the market, the aggregate supply rises and shift back to its initial level. The economy reaches its long run equilbrium level.

A natural disaster that destroys a significant portion of production capacity: This will decrease the production capacity of the firms, as a result the short run aggregate supply decreases and short run aggregate supply curve shift to left. The price level rises and output falls. In the long run, the economy builds the production capacity and increases the production which shifts the economy to its initial long run equilibrium level.

A major technological innovation: This will increase the production capacity of the firms and reduces the cost of production. As a result, the short run aggregate supply rises and short run aggregate supply curve shift to right. The price level falls and output rises. In the long run, the Long run curve shift to rightward, which increases the long run output level and decreases the price level.