Question

1. In a separate diagram, draw each of the following curves and, in your own words, explain their shapes using economic reasoning.

1. Long-run aggregate supply curve.
2. Short-run aggregate supply curve.
3. Aggregate demand curve.

2. Suppose that the government increases its purchases of goods and services.

1. What is the effect on the aggregate demand curve of the increase in government purchases?
2. Using an aggregate supply and aggregate demand diagram, show the short-run effect on the price level and real GDP from an increase in government purchases of goods and services.

3. What occurs when real GDP exceeds potential GDP? What curve shifts in order to restore real GDP to potential GDP? Why does this curve shift?

Answer 1

1) Short run supply curve: In the short run, we assume that resources are underutilised. Therefore, as prices increase, it is favourable to supply more. Hence, SRAS is an upward sloping curve.

Long run aggregate supply: In the long run, it is assumed that all resurces are fully employed. So, higher price does not induce to supply more. Instead, extra demand only shoots up prices. So, LRAS is a vertical line at the full employment level of GDP.

Aggregate demand: Demand reduces as price of a product increases. Similarly on the macroeconomic level, aggregate demand falls with an increase in price.

2) Government purchases form a component of aggregate demand. So, an increase in government purchases shifts the AD curve to the right (AD'). As a result, both GDP and prices increase, which is shown below:

3) If real GDP exceeds potential GDP, there is overheating in the economy, which means that economy is operating beyond its potential level. So, as GDP expands beyond potential level, there is an equal increase in the price. As price rises, aggregate demand falls. Aggregate demand can fall in many ways. Higher price reduce consumption, net exports and investment. Investment falls because of higher interest rates. Interest artes rise because stock of real money holding falls as a rsult of high prices. Hence, AD curve keeps on shifting backwards, until it reaches the potential level of output.