Question

1. Does the Aggregate Demand (AD) curve always slope downward? Discuss and use explanations (interest rate effect, wealth effects, open economy effect to illustrate your answer)

2. The Aggregate Supply (AS) curve slopes upward to reflect the profit motive of businesses. So, why are there two versions of the AS curve( i.e. short run and long- run). Discuss.

Answer 1

Short run aggregate demand curve shows the relationship between price level and quantity of real GDP demanded

by households, firms and government, holding everything else constant.

AD = C + I + G + (X-M)

The components of AD are consumption by households, investment by businesses, government spending and investment and net exports (exports minus imports).

The AD curve is downward sloping because of

1. The interest rate effect. When AD increases, there is increase in AD for money supply and this pushes up the interest rate.
2. The second reason is the real balances effect. When price-levels rise, the purchasing power of money falls and value of financial assets and other wealth held by the population falls.
3. The international trade effect: As the price level in the home country rises relative to other countries, consumers in the home country will buy goods from abroad in preference to their own home-produced goods. At the same time foreigners will find home country’s goods more expensive and will decrease their purchase.

Short run aggregate supply (SRAS) curve shows the relationship between price level and real GDP supplied by firms. The SRAS curve shifts upward. The Long run aggregate supply (LRAS) curve shows the relationship between price level and real GDP in the long run. The level of real GDP in the long run is the potential GDP or full employment. The LRAS is a vertical line and is determined by the number of workers, the capital stock, and the technology.