Effect of Aggregate Demand & Supply-Free-Samples for Students

Question: Discuss about the AS/AD Model. Answer: The AS/AD model The aggregate supply curve represents the total amount of goods and services produced by an economy at all possible price levels. The aggregate demand curve represents the amount of goods and services that can be purchased by the economy at all possible price levels. When both curves are put together, it represents the AS/AD equilibrium in a given economy. The equilibrium point is representative of the equilibrium price level and the real GDP. In the short run, the equilibrium occurs when the GPD quantity demanded is equal to the quantity supplied. In the long run, the real GDP should be equal to the potential GDP. The AS/AD framework shows the response to the economy in response to increase in the aggregate demand (Anderson and Peitz, 2012). An increase in the aggregate demand can result either from increased income levels or an increase in government spending or a fall in the interest rates. In the short run, the AD curve shifts to the right which makes the equilibrium price to increase as well as the real GDP to increase as well. The AD may shift to the right due to an increase in foreign income due to increased world trade. The increase in the foreign income may positively impact the exports of the country which leads to increase in the aggregate demand (Evans, 2016). This movement can be reflected in the housing market where the economy experiences an increase in the house prices. Due to the increase in the levels of income, the money wage rate may stimulate the short run aggregate supply curve to shift leftward. A leftward shift can be caused by the increase in the prices of inputs that are used in the manufacturing of products. For example an increase in the price of the price of non-precious metals may increase th e costs of production which makes the producers produce a little bit less. The equilibrium quantity demanded therefore decreases and the price level is further increased. On the other hand, in the long run, the short run aggregate supply curve shifts leftward such that the Real GDP is at the potential GDP. It therefore leads to a higher level in the price before the increase in the aggregate demand (Berentsen and Wright, 2011). The GDP can also be impacted by the monetary policy. In case of a contractionary monetary policy imposed by the ECB, the money supply in the economy decreases, this leads to a decrease in the GDP. The aggregate spending by the consumers in the market is reduced which reduces the aggregate demand leading to a rightward shift. On the other hand, an expansionary monetary policy by the ECB leads to an increase in the money supply in the economy. This leads to an increase in the aggregate demand and therefore an increase in the GDP. In this way, the increase in consumer spending leads to a leftward shift in the aggregate demand curve that increases the equilibrium price and increase in the real GDP (Heijdra, 2017). The ECB has been implementing an expansionary monetary policy in order to stimulate the economy and support the Euro to level the inflation rates and stimulate economic recovery. In case the ECB selects to pursue an expansionary fiscal policy, there is either an increase in government spending or a decrease in the level of taxes of both. The AD curve shifts to the right as a result. However the extent of the shift due to government spending is dependent on the size of the multiplier. The shift in the AD curve due to a contractionary fiscal policy may be in order to remedy the demand pull inflation. Also in case the ECB had undertaken a debt, a contractionary fiscal policy may raise taxes or decrease government spending in order to account for the debt. The decrease in the money rotation leads to a decrease in the aggregate demand and hence reduced GDP. The Aggregate demand curve therefore shifts to the left. The leftward shift in the Aggregate Demand curve leads to a decline in the price levels as well as a general decrease in the real output. These impacts on the GDP are with the assumption that there is no increase in the Aggregate supply or that the effect s do not happen simultaneously (Saez and MIchaillet, 2015). Graph for inflation rate Inflation is the sustained increase in the general price level over a period of time. In the short run, a decrease in the aggregate supply makes the SAS move further leftward. In this way, the real GDP decreases with an increase in the price level. This period can be known as stagflation since it has both recession as well as inflation. In the event the aggregate demand curve increases and there is a constant SRAS, there leads to a demand pull inflation due to the expansionary gaps that result. In case there are changes in the SRAS with a constant AD, there arises two scenarios. The increase in SRAS may be caused by a decrease in the factor prices such as the price in base metals. It leads to a cost push inflation. In case there is an increase in the aggregate supply and the presence of an expansionary gap, there leads to a deflationary expansion. In case there are simultaneous changes in the AD and the SRAS three events may occur. First, it might lead to a depression in case both of them decrease in a simultaneous manner. It may also lead to a deflation in case the AD decreases and the SRAS decreases in the same level with a constant rate of the LRAS (Shaikh and Shaikh, 2017). Increase in the price of the non-precious metals contributes to the cost of factor prices. The increase in the cost of factor prices therefore leads to an increase in the production costs which negatively affects the Aggregate supply in the short run. The decrease in the aggregate supply leads to a leftward shift in the SRAS which leads to an increase in the price level while at the same time leads to an increase in the quantity demanded. In the case there is a slowdown in the growth of world trade, the aggregate demand is bound to be affected. The decrease in the aggregate demand will lead to a deflationary effect on the economy. A major fall in house prices may lead to an increase in the demand for the houses while leading to a decrease in its supply. This may lead to a decrease in the price level with an increase in the real output. References Anderson, S.P., Foros, ., Kind, H.J. and Peitz, M., 2012. Media market concentration, advertising levels, and ad prices.International Journal of Industrial Organization,30(3), pp.321-325. Berentsen, A., Menzio, G. and Wright, R., 2011. Inflation and unemployment in the long run.The American economic review,101(1), pp.371-398. Evans, A. J. (2016). A Dynamic AD-AS Analysis of the UK Economy, 2002-2010.Journal of Private Enterprise,31(4), 97. Heijdra, B.J., 2017.Foundations of Modern Macroeconomics: Exercise and Solutions Manual. Oxford university press. Saez, E. and Michaillet, P., 2015.An Economical Business-Cycle Model. Working Paper. Shaikh, M., Shah, A.B. and Shaikh, F.M., 2017. Effect of Aggregate Demand and Supply Shocks on Output and Inflation Rate in Pakistan.