Question

1. How do shifts in aggregate demand lead to short run fluctuations? Explain and support your answer with the adequate graph. Explain what happens in the AD-AS model if there is a negative supply shock such as an increase in the oil prices. What do you think are the causes of stagflation in an economy?

Answer 1

1.

It is the demand that creates supply, so shifts in demand causes shift in supply or real output in the economy as well as the general price level in the economy. For example, decrease in demand (Leftward shift in AD), will created reduced real output and lower price. It happens during the recession and can create recessionary gap in the economy. Though, the increase in demand (Rightward shift in AD) will increase the real output and higher price level in the economy. It can be observed in following graph.

If there is a negative supply shock such as rise in oil price, then AS will shift to the left. It will increase the price level and decrease in real output level at the new equilibrium.

When AS ( it will make bigger shift to the left) and AD both shifts to the left direction, then price level rises as well as real output also decreases. It causes increase in unemployment rate. As a result, increase in inflation and increase in unemployment rate both take place at the same time and stagflation is created in the economy.