Question

1. Describe the three curves that describe the AD-AS model and show long run aggregate equilibrium in a graph.

2. Describe and show the AD curve. Include the reasons it slopes downward.

3. Explain the counteracting forces that act against the reasons for a downward sloping AD curve.

4. Describe and show the shift factors for the AD curve. Show how each relates to both increases and decreases in AD.

Answer 1

1)

Equilibrium is achieved when Aggregate demand is equal to Aggregate supply. So in the short run, equilibrium is at point E, where AD = AS.

Eventually, as time progresses, the economy in the long run with utilize all of it's resources ( full employment ) and the Long run aggregate supply curve becomes a vertical line. So, in the long run, Equilibrium is at AD = LRAS or at point F.

2) As we see in the above diagram, AD is a downward sloping line From Y axis to X axis. This is because of the Law of demand in play, as at lower prices, more quantity of goods and services can be produced and sold.

As price and output have an inverse relationship, the aggregate demand ( Aggregate of all individual market demand) is a downward sloping curve, indicating more is sold at lower prices and vice versa.

3) Sometimes, the reasons that make the demand curve downward sloping could act against the law of demand through different exceptions:

1. For example: A continous reduction in price can lead to a deflationary pressure where the aggregate demand in the entire economy contracts significantly.
2. When prices are falling continously, consumer's tend to delay their purchases for non-essential goods.
3. Reduction in prices can result in increase in interest rates as the value for money has risen. As a result, investment and consumption in the economy reduces significantly due to rise in intrest rates.
4. Lower prices can result to lower wages as sellers reduce their supply and the requirement for labor reduces. With lower wages, there is a reduction in real wages and an increase in real debt.

4)

Shift in Aggregate supply is due to favorable changes that affect the demand for commodities. Here are some reasons why AD shifts leftward or rightward:

Rightward Shift ( Increase in AD)

1. Increase in consumer confidence, and as a result more goods are servicesa are purchased.
2. Reduction in taxes, increase in government spending ( Fiscal policy measures ) to increase AD and to increase economic growth.
3. Reduction in Central Bank Rates ( Monetary policy measures to increase AD)
4. Increase in Disposable consumer income
5. Increase in import demand as domestic currency is stronger than foreign currency making foreign goods cheaper.

Leftward Shift ( Decrease in AD)

1. Reduction in Consumer confidence due to uncertain economic / political situation in the country, resulting in lower demand for goods and services.
2. Increase in Taxes , decrease in goverment spending. (Fiscal policy measures to reduce inflationary pressure)
3. Increase in Central bank rates ( Monetary policy measure to reduce inflationary pressure)
4. Decrease in Disposable consumer income.
5. Decrese in import demand as domestic currency is weaker than foreign currency, maing foreing goods more expensive.