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Aggregate Demand, Multiplier Effect, and Fiscal Policy

1. Describe the factors that cause the aggregate demand (AD) curve to shift and the factors that cause the short run aggregate supply (SAS) curve to shift. Explain how each factor described above works in shifting the AD and SAS curves.

2. Explain the difference between expansionary and contractionary fiscal policy and describe how each policy affects aggregate demand, aggregate expenditures, output and income.

3. Explain how the multiplier effect would support Keynes' explanation how economies can fall into recession or depressions.

Solution Preview

Factors that shift the demand curve include increasing income, increasing population, changes in consumer taste, and prices of substitute products. The demand curve describes how quantity varies with price. As consumers become more wealthy, they are willing to spend more one some products. At each price level, more of the good would therefore be consumed. The same process works when consumers' tastes change, or there is an increase in population. If they decide that a certain product is suddenly desirable, they are willing to buy more at every price level. As the market expands due to a larger population, demand also increases. The increasing price of a substitute product can also increase demand. As long as they are still not spending as much as they would on the higher priced substitute, quantity demanded at all price levels will continue to increase. Of course all of these factors work in reverse as well (e.g. if the price of a substitute falls, the demand curve shifts backward).

Factors that ...

Solution Summary

Contractionary vs expansionary fiscal policy; shifting of the AD curve; Keynes and the multiplier