Question

Explain how to use an economic aggregate supply and demand model to forecast a decline in: (a) economic growth; (b) inflation; and (c) the nominal market interest rate.

Answer 1

In each graph, AD0, LRAS0 and SRAS0 are initial AD, long run Aggregate Supply curve and short run Aggregate Supply curves intersecting at point A with initial long run equilibrium price level P0 and real GDP (= Potential GDP) Y0.

(a) When consumption demand, investment demand and/or exports decrease, the aggregate demand falls, which slows down economic growth. Lower aggregate demand shifts AD curve leftward, lowering both price level and real GDP, causing a recessionary gap. In following graph, as AD decreases, AD0 shifts left to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1, creating recessionary gap equal to (Y0 - Y1).

(b) As explained above, when aggregate demand falls, which slows down economic growth. Lower aggregate demand shifts AD curve leftward, lowering both price level and real GDP, causing a decrease in inflation. However, inflation can decrease if short run aggregate supply rises, for example due to lower cost of inputs. Higher aggregate supply shifts SRAS curve rightward, which lowers price level (causing a fall in inflation) and higher real GDP. In following graph, as SRAS0 shifts right to SRAS1, it intersects AD0 at point B with lower price level P1 and higher real GDP Y1.

(c) When aggregate demand falls, investment demand decreases which leads to a decline in nominal market interest rate. Another possible situation is a fall in short run aggregate supply, for example due to higher cost of inputs. Lower aggregate supply shifts SRAS curve leftward, which increases price level and decreases real GDP. A fall in real GDP and output will lead to lower investment demand by firms, causing a fall in nominal interest rates. In following graph, as SRAS0 shifts left to SRAS1, it intersects AD0 at point B with higher price level P1 and lower real GDP Y1.