Question

Consider the AS-AD model of a closed economy.

a. Write down the expressions for the AS and AD curves and interpret the expressions: what is the intuition behind the two curves? What must be true of the model parameters and variables in the long-run equilibrium, i.e. in the steady state?

b. Analyse the effects of a supply shock that causes a temporary increase in inflation, using a diagram. Assume that the shock lasts for one period and then assumes the value zero. Describe the mechanisms that bring the economy back to long-run equilibrium. What happens to aggregate demand?

c. Consider an economy that starts out in steady state when the central bank decides to make the inflation target more ambitious. Analyse the effects of a decrease in the inflation target from ?̅ to ?̅′. Explain the mechanisms behind the adjustment to the new steady state.

d. How would the slope of the AS and AD curves be affected if we instead were to consider an open economy? No derivations are needed, but please motivate your answer.

Answer 1

Answer (a) : The Aggregate Demand (AD) and the Aggregate Supply (AS) of a closed economy are very critical as they adjudge the market and effect the market viciously. The market being a closed economy, therefore, therefore there will very meager impact of the changes in the external economies of scale on this closed economy. The inside market is the sole decider of the fate of the nation. Aggregate demand represents the overall demand for a product or for a group of goods and services. The Aggregate demand is a downwards sloping curve. The aggregate supply of an economy represents the overall supply of a good, product or services in an economy. The aggregate supply curve is an upward sloping curve.

Answer (b):

From the above diagram we can see that AD is the aggregate demand curve in the economy and AS is the aggregate supply curve in the economy. Now, if the economy experiences a shock of inflation rise, the prices of the goods will increase, thereby leading to the people now choosing to buy lesser. Therefore, the demand for the goods will decrease. It is given that the inflationary shock is for a very less period and then the inflation gets back normal to Zero. In this short phase, the supply prevailing in the economy will not get any time to adjust to the increase in the reduced demand. Therefore, the supply will remain the same. At this reduced demand and at the same level of supply, the market to assume its equilibrium at a lower level now. We can see that AD2 is the new reduced demand curve now. The point E2 is the new equilibrium point. At this point, supply of few products will get wasted. To bring back the economy to normal state, supply of the product can be reduced, so that the extra supply in the market will be consumed and the price of the product will not decrease any further.

Answer (c): If the Central Bank decides to reduce the inflationary prices in a steady state economy, The market being in a steady state, there will be a good impact of the reduction of the prices of the product on the steady state economy. Due to the reduced prices, the goods will now be available in the market at lesser rates. This will drive up the demand for the product. Higher demand will need to be met by adequate supply, otherwise, the market prices will shoot up again due to increased demand.

Answer (d): In an open economy, the market conditions are affected by the internal changes in the economy as well as by the external changes of the economy. If in an open market, there is a reduction in the prices of the products, the price of the product will go down by not by much, as there will be importers from the external market who will be eyeing to import more now, due to the reduced prices. Therefore, in the local market, there will be a small reduction in the price level. Therefore, the demand of the product will see a very small rise or a marginal rise. If the supply of the product is adequate, then there will no change in the equilibrium, the slope of the Aggregate Demand curve will slope down by a very small margin, however the aggregate supply curve will remain unaffected.