Question

2. Please briefly define aggregate demand (AD), aggregate supply (AS), and the price level (P). Why do the AD curve slope downwards and what will be the impact on the P if AD curve shifts to the right? Show all of these interactions and the new equilibrium level on the diagram. How do you call this type of inflation according to the theory? (15 pts.) What are the altermative GDP measurement methods? What is the main difference between the methods? (15 pts.) 3.

Answer 1

Ans 2: Keynesian Model uses four main components to reach equilibrium in the economy, namely Aggregate demand, Aggregate supply, Price level and Real GDP(employment level).

Aggregate demand is the sum total demand of the economy. It is the corresponding demand given the level of Real GDP and price. Aggregate demand mainly constitutes of four factors affecting it- Personal consumption, Business Investment, Government Spending, Net Exports. Any changes in the above factors result in a shift in Aggregate demand.

Aggregate supply is the sum total of goods and services supplied by the producers in the economy. It is the corresponding supply given the level of Real GDP and price. Factors affecting the Aggregate supply are Productivity level, Input prices, Business taxes, and regulation. Any changes in the above factors result in a shift in Aggregate supply.

Price level is a range of prices of goods and services in the economy. The equilibrium price level is determined by the intersection of aggregate supply and aggregate demand curves.

The diagram below shows the interactions between the above curves where E shows the equilibrium level.

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The slope of Aggregate Demand curve:

The aggregate demand curve and price level show an inverse relationship. Any increase in price level results in a decrease in the aggregate demand and vice versa. Therefore, the shape of the curve is downward sloping. There are numerous reasons behind the inverse relationship between aggregate demand and price level:

• Real Wealth Effect: the nominal value of wealth remain constant along the curve but the real value of wealth or the purchasing power of an individual keeps falling as the price level increases.
• Interest Rate Effect: With a fall in the price level, people are easily able to make their ends meet and therefore the demand for money falls resulting in decreased interest rates. This decreased interest rate induces investment spending.
• Foreign Purchases: As the price level falls, goods and services appear cheaper to the foreigners, thus increase in demand by foreign countries.

Shifts in Aggregate Demand Curve

the rightward shift of the AD curve can occur due to:

• increase in personal consumption
• increase in business investment
• an increase in government spending
• increase in Net Exports

The diagram below shows the shift in AD curve to AD' which resulted in an increase in the price level from P to P' and Increase in Real GDP from RGDP to RGDP'. This increase in price level due to an increase in aggregate demand is known as Demand-Pull Inflation.