Question

Question 3
Using the aggregate demand and aggregate supply model, explain the effects of
the following on price and real income in Malaysia.
(a) Consumers are worried with the country’s economic progress. [10 marks]
(b) Firms have begun to use more high-tech machineries for production. [10 marks]
(c) The Malaysian government has decided to spend on a major revamp of the public transportation system. [10 marks]
(d) Malaysian higher education system has produced highly skilled employees. [10 marks]

Answer 1

Question 3:

We have analyzed both the short-run and the long-run effects of the given events in the Malaysian Economy, on the price and real income in Malaysia.

All the below figures represent the economy of Malaysia. The X-axis shows the Real GDP and Y-axis shows the price level. Initially the economy is at its long-run equilibrium point A, where the long-run aggregate supply curve (LARS1), the short-run aggregate supply curve (SRAS1) and the aggregate demand curve (AD1) intersect. At this point equilibrium real GDP is equal to the potential level of GDP Y* and the equilibrium price level is P*.

1. Consumers are worried with the country’s economic progress (Refer to Figure 1): This means consumers are pessimist and have low confidence in the growth of economy. A lower consumer confidence indicates that consumers will tend to spend less and save more. A fall in consumption spending reduces aggregate demand and shifts the aggregate demand curve downwards from AD1 to AD2. In the short-run, the economy moves to equilibrium point moves down to point B where equilibrium real GDP falls to Y1 and equilibrium prices falls to P1. In the short run, the economy experiences a Recessionary Gap of “Y1 –Y*”

In the long-run, wages and all other prices are flexible thus in response to a fall in the price level in the short-run, the wages and other production costs too fall. Producers respond to the fall in production costs by increasing production levels. This causes the short-run aggregate supply curve to shift rightwards leading the economy towards its long-run equilibrium level point C. Here, the equilibrium real GDP restores back to its potential level Y* with a further reduction on prices to P2.

2. Firms have begun to use more high-tech machineries for production (Refer to figure 2): In the short-run the initial impact of using more high-tech machineries can be considered as an increase in investment levels. This increases the aggregate demand in the short-run and shifts the aggregate demand curve rightwards from AD1 to AD2. The economy moves towards its short-run equilibrium point B, where equilibrium price as well as equilibrium real GDP increases.

In the long-run, this increase in investment also increases the productive capacity of the economy, due to which the long-run aggregate supply curve shifts rightwards from LRAS1 to LRAS2. Along with this, use of more high-tech machineries means reduction in production cost due to technological advancement. This increases efficiency and reduces average cost to which firms respond by increasing production levels. This causes a rightward shift in short-run aggregate supply curve from SRAS1 to SRAS2. The economy settles at new long-run equilibrium point C, with higher potential level of real GDP of Y1* and without any inflationary pressure i.e. price level restores to P*.

3. The Malaysian government has decided to spend on a major revamp of the public transportation system (Refer to figure 3): The increase in government spending increases the aggregate demand causing a rightward shift in the aggregate demand curve from AD1 to AD2. The economy moves toward its short-run equilibrium point B, where equilibrium real GDP increase to Y1 and the equilibrium price level increases to P1. In the short run, the economy experiences an Inflationary Gap of “Y1 –Y*”

In the long-run, wages and all other prices are flexible thus in response to a rise in the price level in the short-run, the wages and other production costs too increases. Producers respond to the higher production costs by reducing production levels in order to avoid losses. This causes the short-run aggregate supply curve to shift leftwards leading the economy towards its long-run equilibrium level point C. Here, the equilibrium real GDP restores back to its potential level Y* with a further increase in prices to P2.

4. Malaysian higher education system has produced highly skilled employees (Refer to Figure 4): With higher education system, the quality of employees increases. This is considered as an increase in the economy’s maximum productive capacity which causes the long-run aggregate supply curve to shift rightwards from LRAS1 to LRAS2.

This positive supply shock means the short-run equilibrium will have less output than the long-run sustainable level. This leads to a situation of surplus in labor market and the prices of factors of production starts falling. Firms respond to this by increasing production and shift the SRAS to the right until actual output matches the long-run sustainable level. The economy moves to its new long-run equilibrium point B, with lower equilibrium price level P1 and higher real GDP equal to Y1*.