Question

Define capital stock. Use the aggregate demand and supply model to show the effects of a decrease in interest rates in the short run and in the long run. Explain why each curve shifts. Also explain why an increase in consumer spending would not have the same effect in the long run.

Answer 1

Capital stock refers to the assets owned by the organization that facilitate the production process. For example, plants, devices, machine and other equipment are considered to be the capital stock.

With decrease in the interest rate, the aggregate demand (AD) increases due to the increase in consumption spending. It increases AD and it shifts to the right in the short run. Though it creates demand pull inflation and cost of input factors increases. It cause short run aggregate supply to decrease and shift to the left. So, in the long term, real GDP comes back to the potential level, but price level increases in the economy.

The change starts from equilibrium E, then it moves to E1 and then, it comes back to E2. As a result, decrease in interest rate, cause rise in price level or inflation.

Increase in consumer spending, creates inflation and it makes firms to decrease supply and shift to the left. So, the impact is huge in the short run, but in the long run, it comes back to the potential level of the GDP. Hence, in the long run, real variable such as output does not change.