Using an aggregate demand and supply diagram, explain how each of the following

Question

Using an aggregate demand and supply diagram, explain how each of the following scenarios affects the equilibrium price level and aggregate output. Consider first the short-run, then the long-run equilibrium for each scenario.

a) Consumers expect a recession, while resource prices rise at the same time.
b) Foreign income falls as domestic technology improves.
c) Foreign price level rises as domestic government cuts taxes.
d) Government spending falls and a higher future price level is expected.
e) Higher future income and lower price level are expected.
f) Resource prices fall and technology improves.

Explanation / Answer

If consumer expect a recession then they will not spend as much money today as to "save for a rainy day". Thus if spending has decreased, then our aggregate demand must decrease. An aggregate demand decrease is shown as a shift to the left of the aggregate demand curve, as shown below. Note that this has caused both Real GDP to decrease as well as the price level. Thus expectations of future recessions act to lower economic growth and aredeflationary in nature.

If foreign income rises, then we would expect that foreigners would spend more money - both in their home country and in ours. Thus we should see a rise in foreign spending and exports, which raises the aggregate demand curve. This is shown in our diagram as a shift to the right. This shift in the aggregate demand curve cause Real GDP to rise as well as the price level.

If foreign price levels fall, then foreign goods become cheaper. We should expect that consumers in our country are now more likely to buy foreign goods and less likely to buy domestic made products. Thus the aggregate demand curve must fall, which is shown as a shift to the left. Note that a fall in foreign price levels also causes a fall in domestic price levels (as shown) as well as a fall in Real GDP, according to this Keynesian framework.

This is where the Keynesian framework differs radically from others. Under this framework this increase in government spending is an increase in aggregate demand, as the government is now demanding more goods and services. So we should see Real GDP rise as well as the price level.

This is generally all that is expected in a 1st year college answer. There are larger issues here, though, such as how is the government paying for these expenditures (higher taxes? deficit spending?) and how much government spending chaces away private spending. Both those are issues typically beyond the scope of a question such as this.

If the cost of hiring workers has gone up, then companies will not want to hire as many workers. Thus we should expect to see the aggregate supply shrink, which is shown as a shift to the left. When the aggregate supply gets smaller, we see a reduction in Real GDP as well as an increase in the price level. Note that the expectation of future inflation has caused the price level to increase today. Thus if consumers expect inflation tomorrow, they will end up seeing it today.

A rise in firm productivity is shown as a shift of the aggregate supply curve to the right. Not surprisingly, this causes a rise in Real GDP. Note that it also causes a fall in the price level.

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