Question

Assume an economy operating at Full Employment (on the Long Run Aggregate Supply Curve).Using Aggregate Demand and Short-Run Aggregate Supply in each of the following cases state: i) the direction AD would shift, ii) the change in the price level; iii) The change in GDP, iv) whether the economy would end up in a contractionary gap or expansionary gap.

a) There is a decrease in interest rates

b) The is a decline in the value of Household Wealth

c) There is an increase in foreign prices

d) There is a decline in foreign income.

Answer 1

A.

It will cause cost of borrowing to decrease. So, AD will increase and shift to the right. It will increase the real GDP as well as price level at the new short run equilibrium. It will make economy end up with expansionary gap where real GDP will be more than the potential GDP.

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B.

Decrease in household wealth, will decrease consumption. It will make AD to decrease. So, AD curve will shift to the left. It will decrease the real GDP as well as  price level at the new short run equilibrium. It will make economy end up with contractionary gap where real GDP will be less than the potential GDP.

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C.

Increase in foreign price, will cause decrease in imports and increase in exports . It will stimulate the domestic consumption as well. So, AD will increase and shift to the right. It will increase the real GDP as well as price level at the new short run equilibrium. It will make economy end up with expansionary gap where real GDP will be more than the potential GDP.

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D.

Decline in foreign income, means people in foreign country, will buy less from the country in concern. So, export from the country will decrease. It will lead to decrease in AD and AD curve shift to the left. It will cause price level to come down and real GDP to decrease at the new equilibrium. Further, economy will face contractionary gap at the new equilibrium.