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Aggregate Demand & Supply

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Aggregate Demand and Supply

1) In each part of this question, assume that the U.S. economy starts from a situation where real GDP equals potential GDP.

a) A deep recession occurs, how does this event affect AD, GDP, and the price level (P)?

b) The world price of crude oil rises by a large amount, how does this event affect AD, GDP and P?

c) The world price of crude oil rises by a large amount, how does this event affect AS, GDP, and P?

d) U.S. businesses expect future profits to fall, how does this event affect AD, GDP, and P?

Fiscal Policy
2) Explain the change in AD when:

a) Government expenditure increases by $100 billion, which the government
spends on national defense.

b) Taxes are increased by $100 billion.

c) Parts (a) and (b) simultaneously.

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Solution Preview

1

a) Recession => consumers loose confidence in economy => starts to save money => reduces consumption => AD decreases => GDP falls (becayse GDP = C + I + G - NX and C went down) => P falls because demand falls.

b) Price of oil increases => cost of production increases => AS curve shifts up => AD curve will have little changes (because this is a supply side shock) => price goes up because cost of production increases => nominal GDP goes up, but real GDP will not have much change

c) answered in previous part already

d) By the Self-fulfilling prophecy (i.e. if people expect something, then it will eventually happen), expect future profits ...

Solution Summary

Aggregate demand and supply are examined. A deep recession occurs for AD, GDP and price levels are determined.

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