Question

• Distinguish between the real-balances effect and the wealth effect. How does each relate to the aggregate demand curve?
• What assumptions makes the immediate short-run supply curve horizontal? Why is the long-run supply curve vertical?
• Explain how an upward sloping aggregate supply curve weakens the realized multiplier effect from an initial change in investment spending.
• Why does a reduction in aggregate demand in the real economy reduce output rather than prices?
• In early 2001 investment spending sharply declined in the United States. In the two months following the September 11, 2001 attacks on the United States consumption also declined. Use AD-AS analysis to show the two impacts on real GDP.

Answer 1

Real balance effect shows the inverse relationship between price level and quantity of expenditure. Because as price rises, real balance of money will decrease, so consumer purchases less and aggregate demand falls and shift AD curve leftward and if price falls, real balance of money will increase, so consumer increase their expenditure results increase in aggregate demand causes AD curve shifts into right. Wealth effect assumes price level is constant , but changes in wealth causes shift in consumer spending .As wealth increases, consumer increase their consumption expenditure,as a result aggregate demand of good and services increases and shifts AD curve into right b. According to Keynes, aggregate supply lays stress on the stickiness of money wages and money illusion of workers results disequilibrium in labor market. So actual level of output and employment is not determined by supply side factors . Therefore SRAS is horizontal. According to classicals ,LRAS is vertical , because potential output is not related to price level c. Upward sloping aggregate supply curve weaken the realized multiplier effect from an initial change in investment because any increase in aggregate demand due to initial changes in investment leads to increase in both price and output. Higher prices rises the cost of production which reduce the supply of good and services d. Reduction in aggregate demand reduce the consumption demand and investment demand for good and services. Fall in consumption and investment reduces the production and output level in the economy e. Initially U.S. economy is equilibrium at point F where AD and AS curve intersects at price level P * and real output at Y* level. Fall in investment and consumption in U.S. in 2001 , reduced the aggregate demand for good and services in the economy. It shifts AD curve leftward as AD1 and as a result , price level falls to P1 and real output falls to Y1