Question

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8. For each of the following, explain the effect it will have on aggregate expenditure and on aggregate demand curves. (Graphs are not necessary). 5 points each. (a) Due to poor weather, sales are lower than firms expecting, causing inventories to be larger than firms planned. (b) A boom causes consumers to increase their MPCs. (c) A drought destroys many crops leading to a rising CPI. () There is a huge increase in the government budget deficit due to an unexpected eco- nomic crisis.

Answer 1

Ans-8a) Due to poor weather, firms are predicting less sales and increase in inventory. This would lead to a decline in investment of thr firms on new inventory. Also an increase in inventory levels and poor sales would means a decrease in aggregate demand in the economy.

• Aggregate Expenditure will decline (due to decline in investment component and also the consumption component)
• Aggregate demand curve will shift backwards showing a decline in Aggregate demand levels.

b) An increase the MPC's of consumers would mean that the marginal propsensity to consume has increased thereby leading to an increase in consumption in the economy.

• Aggregate expenditure will increase (due to increase in consumption component)
• Aggregate demand curve will shift forward showing an increase.

c) Increase in CPI due to destruction of crops owing to droughts would mean that the general prices have risen due to decrease in supply/shortage. An increase in prices would force the consumers to cut their consumption expenditure.

• Aggregate expenditure will decrease(due to decrease in consumption component owing to higher prices) . However, an increase or decrease in aggregate expenditure would depend on the demand elasticity of the product. If it is price elastic, then the aggregate expenditure will decrease but a price inelastic demand would lead to an increase in the expenditure. (Note: I have taken a general case here i.e. usual behaviour of people in response to a price increase will be decrease in demand and hence decrease in expenditure)
• Aggregate demand curve will experience a contraction along the demand curve showing decline in quantity demanded owing to higher prices.

d) An increase in govt deficit implies increase in the govt spending levels i.e. 'G' component of aggregate expenditure.An increase in govt spending would inject more money in the economy, thereby increasing the purchasing power of the people and hence the aggregate demand.

• Aggregate expenditure will increase (due to increase in 'G component i.e. govt spending)
• Aggregate demand will shift forward showing an increase in demand. (due to increase in purchasing power)