Question

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

   I. The price of crude oil drops significantly due to the application of a new extraction technology known as "fracking". (2.5 marks)

   II. 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)

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

   IV. 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

i) Due to a drop in crude oil prices, the consumption of crude will tend to go up. Since the cost of producing crude is now lower, so the sellers can sell at a lower price as well. The supply curve of the suppliers will shift towards the right. This overall reduces the aggregate supply. Due to ruction in prices, the aggregate demand also goes up so the aggregate demand curve also shifts to the right. The equilibrium quantity will increase.

However, often, to keep the price constant and improve their profit margins, suppliers often cut the production of crude. So even at lower prices, the production of crude is artificially limited which helps to keep the supply low and keep the price high. In this case, the equilibrium point will not be disturbed and the aggregate supply and demand shall remain as it is.

ii) Since the federal government will spend less on defense, it means the overall government spending is going down. Due to reduction in government spending, the money is not circulated and people have less money in their hands. So overall consumption will go down and the aggregate demand will fall. However, the crowding out effect which happens when government borrows will have a reverse effect. So since government spending is reduce, the government does not have to borrow money. So interest rates remain low. In the short run, businesses will want to expand and increase supply. So the aggregate supply curve moves to the right in a small variation while the aggregate demand curve loves to the left largely in comparision to the change of the aggregate supply curve.

iii) Since there is a recession in a country which is a major importer, this will reduce the imports. This will thus increase the net exports since the country will not be able to afford to import but its own production can be exported. This will increase the country's GDP in the short run. Also, since there is export, so production will go up but the demand for goods will fall due to recession. Now because there is low demand, the original supply will not be changed and the extra products will be exported. So the supply curve remains as it is but the aggregate demand curve shifts to the left thus reducing aggregate demand in the domestic market.

iv)Since there is a carbon emission tax, the price of electricity goes up and the profitability of the companies also go down. All in all, there is a 2 fold effect. Because of high price of electricity, the demand for electricity goes down. Thus there is a leftward shift of the aggregate demand curve. Since the cost of production has gone up for the producers, so the supply will also be reduced to keep the price high. Thus the supply curve also shifts leftwards and reduces the aggregate supply.

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