Question

Use the model of aggregate demand and short-run aggregate supply to explain how each of the following would affect real GDP and the price level in the short run.

a. A decrease in government purchases

b. A major improvement in technology

c. A trade surplus

d. A decrease in Labor

Answer 1

a. A decrease in government purchases

Aggregate demand is the sum of consumption + investment + government purchases + net exports. A decrease in government purchases means a decrease in aggregate demand of the economy. This leads to shift the aggregate demand curve leftward. The short run aggregate supply curve being the same, the leftward shift in the aggregate demand curve will lead to decrease in both real GDP and the price level.

b. A major improvement in technology

A major improvement in technology will lead to increase in the production level of the economy which leads to increase in aggregate supply of the economy. This will shift the aggregate supply curve to the right. The aggregate demand being the same, the rightward shift in the aggregate supply curve will lead to increase in the real GDP and decrease in the price level.

c. A trade surplus

Aggregate demand curve is the sum of consumption + investment + government purchases + net exports. A trade surplus means increase in net exports. This will lead to increase in aggregate demand and shift the aggregate demand curve to the right. Aggregate supply curve being the same, rigthward shift in the aggregate demand curve leads to increase in both real GDP and price level.

d. A decrease in Labor

A decrease in labor will lead to decrease in the production level which will decrease the aggregate supply in the economy. A decrease in the aggregate supply curve will lead to leftward shift in it. Aggregate demand curve being the same, a leftward shift in the aggregate supply curve will lead to decrease in the real GDP and increase in the price level.