Question

27. A) Both the price level and Real GDP increased between year 1 and year 5. Explain and diagrammatically represent two things that could have happened to cause this state of affairs? B) Changes in Y in the classical model originate on the supply-side of the economy. Do you agree or disagree? Explain and diagrammatically represent your answer.

Answer 1

SETTO 19+Gt la ADIC+ YYYY output, rGDP UK, > Oulput, eupP VA A >

A.) When there is a case of a rise in output, along with a rise in price levels the rise is brought about by a positive change in components of aggregate demand. The components of aggregate demand are consumption expenditure, investment expenditure, government expenditure, and net-exports. Two things that could bring about such a change are a rise in consumption expenditure due to increased demand as a result of rising incomes, or, a rise in investment expenditure which is brought about by lower costs of borrowing as interest rates drop as a result of expansionary monetary policy. A positive change in the remaining components of AD will bring about a change that follows a similar trend.  

B.) Changes in the level of Y produced in the economy are determined by multiple factors such as changes in both aggregate demand and aggregate supply. As shown in the third diagram, when if there is a change in any of the components of the AD there is a shift in AD, which causes the equilibrium Y to rise. This rise causes input prices to rise in the medium run as wages rise and contracts the aggregate supply to bring the economy back in the long-run equilibrium state. The aggregate supply or supply-side manipulation of Y only occurs when there is a change in the input prices, which can largely depend on demand-side determinants. Therefore I would not agree with the notion that classical models assert that change in Y is due to supply-side. However, as seen in the second diagram the productive potential of the economy at any given point in time will depend solely on the long-run supply-side determinants. Therefore we can conclude that short-run changes in Y can be brought about by demand-side determinants as well as supply determinants, whereas long-run changes in Y can solely be affected by supply-side determinants.