Question

Assume Broncoland has the following aggregate demand (AD) and short-run aggregate supply (SRAS) schedules.

Price Level	Aggregate Demand	Short-Run Aggregate Supply
120	8,250	9,700
115	8,300	9,750
110	8,400	9,700
105	8,500	9,600
100	8,600	9,500
95	8,700	9,300
90	8,800	8,800
85	8,900	8,000
80	9,100	7,000

With the information in the table above in mind, complete and answer the following:

By hand, using pen(cil) and paper, graph the aggregate demand and short-run aggregate supply curves. Be sure to use the following labels:

Label the aggregate demand curve AD and the short-run aggregate supply curve SRAS.

Label the y-axis, PL (for the price level) and the x-axis either RGDP or Y.

What is the equilibrium price level and equilibrium output?

Assume the aggregate quantity demanded increases 900 at every price level. Graph the original and new aggregate demand curves as well as the short-run aggregate supply curve. Label the new aggregate demand curve AD2. What happened to the new equilibrium price and output when aggregate demand increased?

List three factors that would cause aggregate demand to increase.

Go back to the original values for aggregate demand and short-run aggregate supply. Suppose the aggregate quantity supplied decreases 1,100 at every price level. Graph aggregate demand, the original short-run aggregate supply, and the new short-run aggregate supply. What happened to the new equilibrium price and output when short-run aggregate supply decreased?

List three factors that would cause short-run aggregate supply to decrease, and explain why you selected the factors you chose.

Return to the original values of aggregate demand and short-run aggregate supply. Assume the long-run full-employment level of output (often called either potential GDP or the natural rate of output) is equal to 8800. Graph aggregate demand, short-run aggregate supply, and long-run aggregate supply. Remember to label the curves. Also, remember that if the economy is operating at the full-employment level of output, the unemployment rate is equal to the natural rate of unemployment, and the economy experiences full employment of resources.

Return to the original values of aggregate demand and short-run aggregate supply. Assume potential GDP decreases to 7,000. Graph the aggregate demand curve, short-run aggregate supply, and the new potential GDP. Be sure to describe where the economy is operating in the short-run relative to where we want the economy to operate. Is the economy operating at full-employment? Is the unemployment rate greater or less than the natural rate of unemployment?

Inflationary Gaps

An inflationary gap exists when the economy is producing a level of output greater than Potential GDP. With an inflationary gap, the short-run level of output produced in the economy is not sustainable. It is greater than Potential GDP; we are operating outside our production possibilities frontier.

There are shortages of labor and other resources. These shortages of labor and other resources cause nominal wages and other resource prices to increase. This increases production costs, causing the short-run aggregate supply curve to decrease. The short-run aggregate supply curve will continue to decrease until long-run equilibrium is reached where AD = SRAS = LAS.

With that information in mind, do the following:

Return to the original value of aggregate demand and short-run aggregate supply. Assume long-run aggregate supply increases to 9,500. Graph aggregate demand, short-run aggregate supply, and the new long-run aggregate supply. Remember to label each of the parts of your graph. You should also describe where the economy is operating in the short-run relative to where we want the economy to operate. Is the economy operating at full-employment? Is the unemployment rate greater or less than the natural rate of unemployment?

Graph an inflationary gap. Graph the decrease in short-run aggregate supply that will move the economy back to long-run equilibrium. Label the second short-run aggregate supply curve SRAS2.

Recessionary Gaps

A recessionary gap exists when the economy is producing a level of output less than potential GDP. If either an inflationary gap or a recessionary gap exists, the economy does not achieve full employment of resources. Classical School economists believe the economy has a self-correcting mechanism, a natural adjustment process that will take place to move the economy back to long-run equilibrium without any type of government interference.

With a recessionary gap, the short-run level of output produced in the economy is less than the full-employment level of output. We are operating inside our production possibilities curve, and labor and other resources are unemployed. Because there is a surplus of labor and other resources, nominal wages and other resource prices fall. This will decrease production costs, increasing the short-run aggregate supply curve.

With that information in mind, do the following:

Graph a recessionary gap. Graph the increase in short-run aggregate supply that will move the economy back to long-run equilibrium. Label the second short-run aggregate supply curve SRAS3.

Answer 1

The demand and supply curve is given in the figure below

The intital equilibrium output is 8800 and price level is 90.

The aggregatte demand increases to AD1, The equilibrium output increases to 9500 and price level rises to 100.

The aggregate demand in the economy changes due to

• Changes in the real wealth of the consumer prompted the consumer to change their consumption and the aggregate demand in the economy changes.
• Changes in real interest rate makes the investment and consumption goods cheaper or expensive. The consumers and producers change their demand for these goods according to this change. The cheaper investment and consumption goods due to fall in interest rate increases the aggregate demand.
• Changes in expectation about the future state of the economy changes the aggregate demand of the economy. The increase in the optimism about the future state or future expansion in the economy prompted the consumer to buy goods and services that increases consumption demand. The optimism also prompted the producers to invest more as they will see expanding economy will lead to higher profit. The increase in both consumption and investment demand will increase the aggregate demand.
• Changes in the expectation about the future price level will change aggregate demand. If the consumer and producer expect a higher price level in future they will tend to spend more on current period, increasing the aggregate demand.
• A rise in income of the trading partners will tend to increase export and thus aggregate demand.
• Changes in exchange rate influence the relative prices of the export and import. An appreciation of home currency will lead to cheaper imports and expensive export. This will decline export and increase import leading to fall in net export and aggregate demand.

The shift in short run aggregate supply is given in the figure below

As aggregate supply decreases the output decreases to 8500 and the price level rises to 105.

The factors that changes the short run aggregate supply are

• Changes in resource prices change the cost of production and aggregate supply changes accordingly.
• Changes in expected rate of inflation changes the aggregate supply in the short run. If the producers’ think that price will go up in future, they will simply hold back the supply in order to get higher prices in the next period. This will decrease the aggregate supply in the short run. Similarly, a decrease in expectation about future prices will increase short run supply.
• The supply shocks, such as change in weather or change in price of the imported resources will change the supply in the short run.