Question

1e. What six factors shift the aggregate demand curve?

1f. What shape is the long run aggregate supply curve?

1g. Explain why LRAS is this shape.

1h. What is the natural rate of output?

1m. Explain how the economy returns to the long run level of output

Answer 1

1e. The six factors that shift the aggregate demand curve are-

• change in household consumptions - Increase in household consumption will shift the AD curve to the right and vice versa.
• change in investment spendings - Increase in Investment spendings will also shift the AD curve to the right and vice versa.
• change in goverment expenditure - Increase in government expenditure will also increase the AD curve and shift it rightwards.
• change in net exports - Increase in net exports will increase the AD curve and shift it rightwards and vice versa.
• change in taxes - An increase in taxes will reduce the AD curve and vice versa.
• change in money supply - Increase in money supply will increase the AD curve and shift it rightwards.

1f. The long run aggregate supply curve is a vertical line parallel to the y-axis.

1g. In the long run, the economy is at full level of employment and the output is produced at maximum capacity which is why the long run supply curve is a vertical line parallel to the y-axis.

1h. The natural rate of output would be the output produced at the natural level of employment in the long run when the production is at its maximum capacity and at an optimum level. The economy will always produce at its natural rate of output and hence returns back to this point automatically even after an economic shock.

1m. Suppose, an economic shock caused an increase in inflation which will decrease the real wages of labors in an economy. As a result of which the labors will demand higher wages in anticipation of an increase in expected inflation in the future. This will lead to a decrease in the production whereas the price in the economy rises. The output will fall as a result of decrease in production. This will continue till the economy goes back to its natural rate of output at full employment level. Hence, the economy foes back to its natural level of employment output while keeping the prices high.