Question

1. Describe the effects of each of the following events on the US economy (i.e. What may happen to the price? To the real output?). Explain briefly what cause these effects (i.e. What happens to determinants of AD or AS or both? Why? ).Illustrate your answers in given AD-AS diagrams. Label your diagrams and changes carefully.

1. Consumers are confident about the future employment prospect.

            P                                     AS                                                   

           

               

                                                AD

                                                                        Y        

1. Firms are very pessimistic about the economic outlook.

                       

            P                                     AS   

Answer 1

In both the graphs, AD0 and LRAS0 are initial aggregate demand and short-run aggregate supply curves intersecting at initial equilibrium point A with initial price level P0 and real GDP Y0.

(1)

When consumers are more confident about future employment, this increases consumer confidence, leading to an increase in consumption. Higher consumption increases aggregate demand, shifting AD curve rightward and increasing both price level and real GDP. So:

P - Increase

AD - Increase

AS - No change

Y - Increase

In following graph, AD0 shifts rightward to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1.

(2)

When firms are more pessimistic about business outlook, this decreases business confidence, leading to a decrease in business investment. Lower investment decreases aggregate demand, shifting AD curve leftward and decreasing both price level and real GDP. So:

P - Decrease

AD - Decrease

AS - No change

Y - Decrease

In following graph, AD0 shifts leftward to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1.