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Supply and demand to explain GDP changes

1. "The aggregate demand curve slopes downward, because when the price level is lower, people can afford to buy more, and aggregate demand rises. When prices rise, people can afford to buy less, and aggregate demand falls." Is this a good explanation of the shape of the AD curve? Why or why not?

2. By using aggregate supply and aggregate demand curves to illustrate, describe the effects of the following events on the price level and on equilibrium GDP in the long run, assuming that input prices fully adjust to output prices after some lag:

A) An increase occurs in the money supply above potential GDP.

B) A decrease in government spending and in the money supply with GDP above potential GDP occurs.

C) Starting with the economy at potential GDP, a war in the Middle East pushes up energy prices temporarily. The Fed expands the money supply to accommodate the inflation.

Solution Preview

This description of the AD curve does not include the aspect of scarcity. People are willing to pay for more goods that are in short supply. In essence, they bid against each other, so that only those with enough income and a great need will end up with the goods that are in very short supply.

A increase in the money supply would shift the demand curve outward to a higher level of nominal GDP and price. ...

Solution Summary

Using aggregate supply and aggregate demand curves to describe the effects various events on the price level and on equilibrium GDP in the long run, assuming that input prices fully adjust to output prices after some lag.

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