Question

Using the aggregate demand – aggregate supply (AD-AS) diagram, show how the four economic events would affect economic activity and the price level. (Note: use a separate AD-AS diagram for each event)
(a) An improvement in the marketing and selling skills of firm managers;
(b) An increase in personal income tax;
(c) An increase in exports;
(d) A significant destruction in an economy’s capital stock because of war;

Answer 1

(a) An improvement in marketing and selling skills of firm managers is a positive supply shock that shifts the AS curve to the right. This can be seen as a positive productivity shock in the economy since managers are essentially inputs in the production process. Thus, the overall price level reduces from Po to P1 while real output increases Yo to Y1 as shown in below diagram-

(b) An increase in personal income tax reduces the personal disposable income. As a result, overall consumption declines and hence overall real output also declines (along with price level) once AD curve shifts to the left as shown below -

(c) An increase in exports will shift the AD curve out as overall aggregate spending increases due to an increase in exports. As a consequences, the overall price level and output in the economy also increases as shown as below -

(d) If economy's capital stock is destroyed due to war then the AS curve will shift to the left. The equilibrium price level in the economy will increase while equilibrium output will decrease -