Question

1. Explain how each of the following events would affect the aggregate demand curve.
a. Lower interest rates (5 points)
b. A decrease in net exports (5 points)
c. A decrease in the price level (5 points)
d. Slower income growth in other countries (5 points)
e. A decrease in imports (5 points)

2. Explain how each of the following events would affect the long-run aggregate supply curve.
a. A lower price level (5 points)
b. A decrease in the labor force (5 points)
c. A decrease in the quantity of capital goods (5 points)
d. Technological change (5 points)
e. An unexpected decrease in the price of an important raw material (5 points)

3. Starting from long-run equilibrium, use the basic aggregate demand and aggregate supply diagram to show what happens in both the long run and the short run when there is a decline in wealth. (10 points)

4. Beginning with long-run equilibrium, use the aggregate demand and aggregate supply model to illustrate what happens in the short run when the economy suffers a negative supply shock. (10 points)

5. Using the aggregate supply and demand model, illustrate what happens in the long run when the economy suffers a supply shock. Begin your analysis by assuming the economy has suffered the supply shock in the short run, but has not yet adjusted to it in the long run. (10 points)

6. Starting from long-run equilibrium, use the basic aggregate demand and aggregate supply diagram to show what happens in both the long run and the short run when there is an increase in wealth. (10 points)

7. Hurricane Katrina resulted in a decline in oil production infrastructure along the gulf coast. As a result there was an unexpected decline in oil and natural gas supplies in 2005. Suppose that this caused an increase in the price level and a decline in real GDP in 2006. Also assume that potential real GDP continued to grow due to other factors. You can assume the aggregate demand curve did not change. Show the macroeconomic equilibrium for 2005 and 2006 using the dynamic aggregate supply and aggregate demand model.

Answer 1

1. a. A fall in interest rates or lower interest rates means that loans will now become cheaper, as a result of which, investment will increase. As investment is an important component of aggregate demand, the aggregate demand will increase shifting the aggregate demand curve to the right.

b. A decrease in next exports would mean a fall in the domestic income and as a result, the aggregate demand curve will shift to the left.

c. A decrease in the price level would mean that consumers will have more purchasing power and as a result of this, the quantity demanded will increase and there will be a rightward movement [not shift] along the aggregate demand curve.

d. Slow income growth in other countries will mean that their demand for domestic good will decrease. This would result in a fall in exports and a resultant decrease in net exports leading to a leftward shift in the aggregate demand curve.

e. A decrease in imports against exports would mean an overall increase in net exports. This increase in net exports will be captured positively through a rightward shift in the aggregate demand curve.