(See related pages)
|
|
|
| Graphing Exercise: Aggregate Demand - Aggregate Supply The aggregate demand - aggregate supply (AD-AS) model is useful for analyzing changes in both real GDP and the price level. Changes in either aggregate demand, aggregate supply, or both can help to explain recession and unemployment, inflation, and economic growth. Now click here to view an interactive exercise. This will open a new browser window. Then answer the questions below. If you have clicked on the link above and cannot see the interactive exercise, you may need to install a free Java plugin for you internet browser. Click here for the plugin. The graph shows the aggregate demand and aggregate supply curves for a hypothetical economy. The AD curve shows an inverse relationship between the aggregate price level and real GDP. This is because an increase in the price level: 1) reduces the real value of dollar-denominated assets, which reduces consumption expenditures; 2) increases the demand for money, which increases interest rates and thereby reduces investment expenditures; and 3) makes domestic goods less attractive to foreigners, which reduces net exports. The aggregate supply curve, on the other hand, reflects the costs of producing a given level of GDP. At very low levels of GDP, resources are unemployed and output may increase with no upward pressure on the price level. However, as real GDP approaches full employment, bottlenecks for some resources appear and costs begin to rise. The price level must rise sufficiently to cover these higher production costs. At some point, however, even higher prices will not attract additional output. The economy has reached its production capacity. The economy is initially at the full employment level of real GDP, labeled Q, and the price level is stable at price level P. To use the graph, click and drag either the AD or AS labels to shift the aggregate demand or aggregate supply curve, respectively, to a new location. The button labeled Reference Lines will toggle on or off the previous locations of the AD and AS curves and the corresponding price and GDP levels. Hitting Reset will restore the economy to full employment GDP and a stable price level. 1. Starting from full employment, what will be the impact of an increase in desired consumption expenditures? AnswerClick Reset to begin from full-employment GDP. An increase in consumption will increase aggregate demand. Click on the AD label and drag it to the right. The shortage of goods and services will start to pull up the price level and provides an incentive for firms to increase their production. The price level and real GDP both rise. 2. Suppose the economy is operating in the vertical range of AS and the government lowers taxes. What effect will this policy have on real GDP and the price level? AnswerDrag the AD curve to the right until it intersects the AS curve in its vertical range. Click on the Reference Lines toggle to establish this as the initial equilibrium. Next, drag the AD curve to the right to illustrate the effect of lower taxes. The price level rises, but no further increase in real GDP is forthcoming because the economy is already operating at its capacity. 3. Suppose the economy is in a deep recession. The government increases the money supply, thereby reducing interest rates. Will this policy increase real GDP? Will it affect the price level? AnswerDrag the AD curve to the left until it intersects the AS curve well into its horizontal range. Release the mouse button to establish this as a starting point. Then, click and drag the AD curve to the right. Initially, real GDP may increase without affecting the price level. However, continued increases in the money supply (further increases in AD) will cause the price level to rise. 4. Suppose the economy is operating at full employment and prices are stable. All else equal, will an increase in wages and salaries increase the aggregate price level? AnswerClick Reset to establish an initial full-employment, stable-price equilibrium. An increase in wages and salaries will decrease aggregate supply. Click and drag the AS label to the left. The price level rises and real GDP falls, a condition known as "stagflation." 5. The late 1990s were a period of dramatically rising stock values and rising labor productivity. Real GDP increased, yet prices remained relatively stable. How might this be explained by the AD-AS model? AnswerClick Reset and note the initial values of real GDP and the price level. Rising stock values increased consumer wealth and expenditures, which increased AD. Click and drag AD to the right. By itself, this would raise both real GDP and the price level. Rising productivity, however, caused a reduction in unit costs and caused AS to increase. Click and drag the AS curve to the right. The price level falls as real GDP increases. Compared to the initial equilibrium, the price level has remained relatively constant while real GDP increased. |