Question

1. Identify the ways in which each of the following determinants would have to change
if each was causing a decrease in aggregate demand: consumer wealth, consumer
expectations, business taxes, national income in countries abroad, exchange rates.

2. What are the three time horizons used to categorize aggregate supply? What is the
difference between the immediate short-run and the short-run aggregate supply?

3. Describe each of the following outcomes in terms of shifts in aggregate demand or
aggregate supply curves.
(a) A recession deepens while the rate of inflation increases
(b) The price level rises sharply while real output and employment increase
(c) The price level falls, but the unemployment rate rises
(d) Real output rises, unemployment rate falls, and the price level rises

4. What are two underlying factors affecting input prices? How does a change in input
prices affect aggregate supply?

5. Differentiate between “demand-pull” and “cost-push” inflation in the basic aggregate
demand and aggregate supply model.

Answer 1

1. Consumer wealth - The consumer wealth has to decrease for a decrease in the aggregate demand. The decrease in consumer wealth can be caused due to an increase in the price level.

Consumer expectations - For the aggregate demand to decrease lower inflation rate should be expected by the consumer.

Business taxes - The rate of business taxes has to increase for a decrease in the aggregate demand. An increase in taxes will reduce the profit and output.

National income in countries abroad - For the aggregate demand to decrease the national income of countries abroad must decrease. A decrease in income abroad will decrease the amount of exports along with a reduction in aggregate demand.

Exchange rates - The exchange rate should be higher for a decrease in aggregate demand. This is because if the exchange rates are higher , the amount of exports will be lower. This inturn decreases the aggregate demand.

2. The three time horizons of aggregate supply are immediate short run, short run, and long run.

The immediate short run aggregate supply is characterized by a constant price level and a varying levels of output. The short run aggregate supply, on the other hand is characterized by a change in both price level and output.

3. a) When the recession deepens with an increase in inflation rate it causes the aggregate supply curve to shift to the left. This will lead to an increase in the price level at the same time the output will decrease.

b) There will be a rightward shift in the aggregate demand. The rightward shift in aggregate demand with a price rise increases the output and employment.

c) There will be a leftward shift of aggregate demand.

d) There will be a rightward shift of aggregate demand as the employment increases ( reduction in unemployment rates).

4. The two underlying factors affecting the prices of inputs are the availability of inputs and the income generated by using the inputs.

If the prices of inputs increase there will be a reduction in aggregate supply. On the other hand if the prices of inputs decrease there will be an increase in the aggregate supply as the cost of production decreases.

5. Demand pill inflation is characterized by an increase in demand for goods and services. Here the purchasing power with the people is high in comparison with the availability of the goods in the economy.

Cost Push inflation refers to an increase in the price level due to an increase in the cost of production of the goods. This is because the inputs used in the production process has become more expensive. This inturn increases the price level.