Question

Question 1:  

1. [5 marks]Explain the three reasons why the AD curve slopes downward. State an event that will shift the AD curve, which way it will shift the AD
2. [5 marks]Suppose that the economy is in LR equilibrium. Draw a carefully labelled AD-AS diagram to show the initial LR equilibrium.
3. [5 marks] Show on the above diagram the effect of a drought that destroys crops of many farmers. Carefully explain all 4 steps to show and explain what will happen in the short run? What is this situation called? How the economy will arrive back to its LR equilibrium without any policy involvement. Make sure to include all the relevant details.

Answer 1

Ans.

Price Level AS AS P P AD Y Y Output

a) Reasons due to which AD curve may shift downwards are,

- Decrease in government spending, this leads to decrease in aggregate expenditure decreases aggregate demand for goods and services which shifts the aggregate demand curve downwards.

- Decrease in financial wealth of households, this decrease in financial wealth of consumers leads to decrease in autonomous consumption leading to decrease in aggregate demand for goods and services shifting the aggregate demand curve downwards.

- Decrease in foreign income level, this decreases the demand for exports from the home country. This decreases the net exports from home leading to decrease in aggregate demand for goods and services shifting the aggregate demand curve leftwards.

b) The long run equilibrium level is represented by the output level Y and price level P.

c) A destroy of crops will decrease the aggregate supply leading to shift in aggregate supply curve downwards from AS to AS'. This leads to a shortage of goods in the economy causing the price level to rise from P to P' and thus, output falls from long run level Y to Y'.
In long run, the increased price level will mean that the real wages of the workers have decreased leading to decrease in cost of production which makes the production units to produce more increasing the aggregate supply of goods and services shifting the aggregate supply curve rightwards back to AS from AS' and moving the equilibrium back to long run with price level P and output level Y.

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