determine the effect on either the aggregate demand curve (is it a rightward or
ID: 1234673 • Letter: D
Question
determine the effect on either the aggregate demand curve (is it a rightward or a leftward shift?), the aggregate short-term supply curve, and the long-term aggregate supply curve (does the upward sloping portions of the SAS curve shift left or right, or does the vertical portion of the LAS curve shift to the right or to the left?). Also determine the effect on the price level, the real output level and employment/unemployment. Provide an explanation and express this graphically using the AS/AD macro model.In the summer of 1953, the Korean War ended and government expenditures decreased. In terms of the AS-AD model, this change should have shifted the AD curve to the left. A cut in government spending reduces economic activity and shifts the AD curve to the left.
Explanation / Answer
he AD-AS or Aggregate Demand-Aggregate Supply model is a macroeconomic model that explains price level and output through the relationship of aggregate demand and aggregate supply. It is based on the theory of John Maynard Keynes presented in his work The General Theory of Employment, Interest, and Money. It is one of the primary simplified representations in the modern field of macroeconomics, and is used by a broad array of economists, from libertarian, Monetarist supporters of laissez-faire, such as Milton Friedman to Post-Keynesian supporters of economic interventionism, such as Joan Robinson. The conventional "aggregate supply and demand" model is, in actuality, a Keynesian visualization that has come to be a widely accepted image of the theory. The Classical supply and demand model, which is largely based on Say's Law, or that supply creates its own demand, depicts the aggregate supply curve as being vertical at all times (not just in the long-run) The AD curve is defined by the IS-LM equilibrium income at different potential price levels. The Aggregate demand curve AD, which is downward sloping, is derived from the IS – LM model. IS-LM Curve AD-AS Curve It shows the combinations of the price level and level of the output at which the goods and assets markets are simultaneously in equilibrium. The above figure showing IS and LM curves, where LM curve shifts downward to the right to LM’ and thus shifting the new equilibrium to E’ where both goods and money market gets cleared. Now, the new output level Y’ correspond to the lower price level P’. Thus a reduction in price, which is shown in the figure, leads to an increase in the equilibrium and spending. The equation for the AD curve in general terms is: where Y is real GDP, M is the nominal money supply, P is the price level, G is real government spending, T is an exogenous component of real taxes levied, and Z1 is a vector of other exogenous variables that affect the location of the IS curve (exogenous influences on any component of spending) or the LM curve (exogenous influences on money demand). The real money supply has a positive effect on aggregate demand, as does real government spending (meaning that when the independent variable changes in one direction, aggregate demand changes in the same direction); the exogenous component of taxes has a negative effect on it. [edit]Slope of AD curve The slope of AD curve reflects the extent to which the real balances change the equilibrium level of spending, taking both assets and goods markets into consideration. An increase in real balances will lead to a larger increase in equilibrium income and spending, the smaller the interest responsiveness of money demand and the higher the interest responsiveness of investment demand. An increase in real balances leads to a larger level of income and spending, the larger the value of multiplier and the smaller the income response of money demand. This implies that: The AD curve is flatter, smaller is the interest responsiveness of the demand for money and larger is the interest responsiveness of investment demand. Also, the AD curve is flatter, the larger is the multiplier and the smaller the income responsiveness of the demand for money. [edit]Effect of Monetary Expansion on the AD curve An increase in the nominal money stock leads to a higher real money stock at each level of prices. In the asset market, the decrease in interest rates induces the public to hold higher real balances. It stimulates the aggregate demand and thereby increases the equilibrium level of income and spending.Thus, as we can see from the diagram, the aggregate demand curve shifts rightward in case of a monetary expansion. Aggregate supply The aggregate supply curve may reflect either labor market disequilibrium or labor market equilibrium. In either case, it shows how much output is supplied by firms at various potential price levels. The Aggregate supply curve (AS curve) describes for each given price level, the quantity of output the firms are willing to supply.
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