Question

Consider a macroeconomy was initially at equilibrium level of real GDP.

Using an aggregate demand and aggregate supply diagram or model of the economy, illustrate and explain the short-run consequences of the following events upon an economy:

1. The Central Bank within the economy lifts interest rates:

2. There is an increase in private domestic investment spending;

3. An increase in the good and services tax (GST);

4. An appreciation or rise in the foreign exchange rate value of the economy’s currency;

5. A fall in real estate prices in the capital cities of the country (hint: think of the effect upon people’s wealth levels.

(2 marks each)

Answer 1

In each graph, initial equilibrium is at point A where AD0 (aggregate demand) and SRAS0 (short-run aggregate supply) curves intersect, with initial equilibrium price level P0 and real GDP Y0.

(a)

Higher interest rate lowers investment, which reduces aggregate demand, shifting AD curve leftward and lowering both price level and real GDP. In following graph, AD curve will shift leftward from AD0 to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1.

(b)

Higher investment spending will increase aggregate demand, shifting AD curve rightward and increasing both price level and real GDP. In following graph, AD curve will shift rightward from AD0 to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1.

(c)

Higher GST will increase production cost, so firms will decrease production, reducing aggregate supply. SRAS curve will shift to left, increasing price level and decreasing real GDP. In following graph, SRAS curve will shift left from SRAS0 to SRAS1, intersecting AD0 at point B with higher price level P1 and lower real GDP Y1.

(d)

Appreciation of domestic currency reduces exports and increases imports, thus decreasing net exports and reducing aggregate demand. This shifts AD curve leftward and lowers both price level and real GDP. In following graph, AD curve will shift leftward from AD0 to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1.

(e)

Lower real estate price will reduce consumer wealth, so consumption demand will fall, reducing aggregate demand. This shifts AD curve leftward and lowers both price level and real GDP. In following graph, AD curve will shift leftward from AD0 to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1.