Question

In: Economics

1. Why is the aggregate demand curve downward sloping? 2. What factors may cause the short...

1. Why is the aggregate demand curve downward sloping? 2. What factors may cause the short run and the long run aggregate supply curves to shift? 3. What is the Classical view of economic management and how is this different from Keynesian's view?

use key terms and be descriptive.

Solutions

Expert Solution

(1)

Aggregate demand curve is downward sloping in the price level-real GDP plane as result of three effects.

(A) Real balances effect (Pigou)

When price level increases (decreases), real wealth of consumers decreases (increases), therefore quantity of consumption demanded decreases (increases). This decreases (increases) the quantity of real GDP demanded, leading to an inverse relationship between price level and real GDP.

(B) Interest rate effect (Keynes)

When price level increases (decreases), interest rate increases (decreases), lowering (raising) the quantity of investment demanded. This decreases (increases) the quantity of real GDP demanded, leading to an inverse relationship between price level and real GDP.

(C) Exchange rate/Net exports effect (Mundell Fleming)

When price level increases (decreases), exportable goods become less competitive and imported goods become cheaper, which lowers exports and raises imports, decreasing (increasing) the quantity of net exports. This decreases (increases) the quantity of real GDP demanded, leading to an inverse relationship between price level and real GDP.

(2)

Short-run aggregate supply (SRAS) can shift due to following factors:

- A rise (fall) in input prices will shift SRAS leftward (rightward).

- An increase (decrease) in factors of production will shift SRAS rightward (leftward).

- A technological advancement (deterioration) will shift SRAS rightward (leftward).

- An increase (decrease) in productivity will shift SRAS rightward (leftward).

Long-run aggregate supply (LRAS) can shift due to following factors:

- An increase (decrease) in factors of production will shift LRAS rightward (leftward).

- A technological advancement (deterioration) will shift LRAS rightward (leftward).

NOTE: As per Answering Policy, 1st 2 questions are answered.


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