Question

Assume an economy operates the intermediate range of its aggregate supply curve

1. Describe the factors that impact on the aggregate demand and factors that impact on aggregate supply

2. State the direction of effect on aggregate demand or aggregate supply for each of the following changes in the conditions:

   1. ​​​​​​The price of crude oil drops significantly due to the application of a new extraction technology known as "fracking".

   2. A new strategic pact with a group of neighbouring nations is struck which the federal government judges will allow it to spend significantly less on defence for a few years. (2.5 marks)

   3. A severe recession occurs in a country which has been a major importer of the nation's exports. (2.5 marks)

   4. A new carbon emission reduction tax is introduced by the government which is imposed on the industry and electricity generators. (2.5 marks)

Answer 1

Factors that affect AD:

- Government Policy of Spending and Taxes

- Change in Exchange Rate

- Change in expected inflation rate

- Business Expectations

- Rate of Interest

- Investment spending and consumption

- Net Exports

Factors that affect AS:

- Changes in Technology

- Changes in cost of production

- Supply chain disruptions

- Human Capital

The price of crude oil drops significantly due to the application of a new extraction technology known as "fracking".

New technology will lead to an improvement in the supply of crude oil in other countries and reduction in the cost of production of firms. This is called Positive Supply Shocks. Consequently, the AS curve will shift to the right.

A new strategic pact with a group of neighbouring nations is struck which the federal government judges will allow it to spend significantly less on defence for a few years.

Less government spending will reduce the G part in AD equation

AD = C + I + G + NX

So, the aggregate demand in the economy will fall and the AD curve shifts to the left

A severe recession occurs in a country which has been a major importer of the nation's exports

A severe recession in a foreign country will reduce the domestic country's exports of goods and services.

So, NX = X - M where X = exports and M = imports

NX will fall significantly. The national income and the aggregate demand will fall. So, AD curve shifts to the left

A new carbon emission reduction tax is introduced by the government which is imposed on the industry and electricity generators

This is an increase in the current taxes imposed on the industry. Such policy is called Contractionary Fiscal Policy. Increased taxes will discourage the demand by the industries. Hence, the AD curve shifts to the left.