Question

Macroeconomic (a) Draw an AS-AD chart showing the economy initially in AS-AD equilibrium. Next, suppose the price level target is raised. Using your AS-AD chart, illustrate the effect on the economy in the short run. Briefly explain, with reference to the chart.

(b) Following the price level target increase in part (b), draw a chart identifying the AS-AD equilibrium to the medium run. Illustrate and carefully explain, with reference to the chart, the economy’s transition path from short run AS-AD equilibrium to the medium run equilibrium.

(c) Draw an IS-LM chart to match the above AS-AD scenario and, with reference to the chart, illustrate and explain the economy’s transition path [ie. following the price level target increase assumed in parts (b)-(c) above] from short run to long run equilibrium, in terms of IS and LM curves.

(d) Summarise your results above in the medium run:

        output falls/rises/remains unchanged (circle correct answer),

        the price level falls/rises/remains unchanged (circle correct answer),

        and the interest rate falls/rises/remains unchanged (circle correct answer).

This outcome illustrates the concept known as the _________________ of money (fill in the blank)

Answer 1

Answer to point a) and b)

The equilibrium in Macroeconomics is a condition where Aggregate Demand and Aggregate Supply are equal. Without any influences of the external factors, price and quantity of a good or service remains unchanged (and at equilibrium, where Aggregate Demand=Aggregate Supply). This equilibrium is represented on the AD-AS Model where demand and supply intersects each other. In the longer time period, change or increase in Aggregate Demand of any good or service tends to increase the output and price of that particular good or service. And Aggregate Supply only get affected by changes in other factors like capital, labour and technology (and other techniques and tools of prpduction). The extent to which the Aggregate Demand increases the output and price of a good or service does only get determined by Aggregate Supply. (refer to Diagram 1)

If there is no more extension in the production of a good or service (hence, supply remains unchanged), but Aggregate Demand tends to increase, it would lead to a higher price until and unless the quantity demanded is pushed back to the equilibrium. And if Aggregate Supply remains unchanged and also, there is less demand in the market than supply of a good/service, surplus of a good/service tends to exist, which further leads to a lower price. If demand in the market remains unchanged and supply increases, then also there would be larger surplus of a good/service available, hence, leading to lower price. Whereas, if demand remains unchanged, and supply also decreases upto the extent which isn't sufficient to meet existing demand, a shortage of that same good or service would occur, leading to higher price of that particular good/service.

Equation used to calculate Aggregate Demand (in case of Open Economy)

AD = CONSUMPTION + INVESTMENT + GOVERNMENT SPENDING + NET EXPORTS (EXPORTS - IMPORTS)

And as a result of Monetary Expansion (in case of money supply rises), the curve that depicts Aggregate Demand shifts to the right. And if the money supply falls, the Aggregate Demand curve shifts again to the left.

And this AS-AD Model represents the use of Theory of Demand and Supply in order to find out the equilibrium price-quantity.

Aggregate Demand shifts to the right when there is monetary expansion in an economy. This works as follows. When the nominal money stock/supply rises in an economy, further it leads to higher real money stock/supply at each level of prices. And due to a further decline in interest rates, it leaves the public with higher real balances which increases the purchasing power (level of income and spending) of the public, and hence, a rise in Aggregate Demand. On the other hand, if the nominal money supply falls in an economy, it leads to the shift of demand curve to the left. (Last diagrams 2 & 3)

Aggregate Supply tends to shift outwards, causing equilibrium price to fall and equilibrium quantity to suddenly rise. It may be due to the situation where the labor cost and another input, factors of production or technology becomes cheaper than earlier, which tends to shift the Aggregate Supply curve outwards. But during the short run, there is only one factor of production, i.e., capital, which is assumed to be fixed variable. And the fixed factor never stops the curve's ability to shift outwards, and it tends to increase the quantity supplied as there is an increase in the output produced in an economy and a decrease in the Growth Domestic Product at given prices (tending prices to fall). Examples may include that any wage rate decline, improvements in technology and accumulation of more and more physical and human capital would tend to shift the supply curve to the right. In the long run, this curve is often seen as statis as it shifts but at a slower pace (at this point, an economy is assumed to be used optimally). (Last diagrams 2 & 3)

Answer to point c) Diagram 4. The IS-LM model

The lower consumer sentiments and if the consumer confidence tends to fall, there would be a shift in the IS curve to the left. Now, assume that market is in equilibrium. Now what happens when GDP goes up? It would raise demand for more money in the hands of public. And if price level and money supply are fixed at that point, then equilibrium can only be restored through higher interest rates and hence, say, higher interest rates would help pushing back the curve to the equilibrium. That's why the LM curve slopes upward. (as shown in the diagram 4)

Answer to point d) output falls

Price rises

Interest rate rises

Fill in the blank. Keynesian's Quantity Theory of Money