Question

Aggregate supply and demand problems

UL uld wnen & bank becomes insolvent? Explain res B. Aggregate Supply and Demand Problem ur knowledge of aggregate supply and demand analysis, as we o answer this part. In each case, analyze the mp Use yo ll as the "shocks" on the nation's employment rate, real GDP, GDP gap, and price n addition, illustrate the impact of each "shock" using an aggregate level. I ly and demand diagram. Pinally Y, analyze the policy options available to tne governmene totse he harmEul impact of each of these shocks. (1) A dramatic increase in oil prices (2)A collapse in the stock market; (3)A large increase in military spending (4) Business leaders become less certain and pessimistic about their future profits (5) An appreciation of the dollar. Potential Output Price Level AS 120 110 100 70 AD Real GDP/Output Trillions of Dollars) 18 19 20 21 22

For each scenario analyze the impacy of the “shocks” on the nation’s employment rate, real GDP, GDP gap anf price level. In addition illustrate the impact of each shock using an aggregate supply and demand diagram. Finally, analyze the policy options available to the government to offset the harmful impact of each of these shocks.

Answer 1

The aggregate supply shows the amount of goods and service supplied in an economy at a different price levels. The aggregate supply is an increasing function of the general price level. As price level increase more is supplied and as price level decrease less will be supplied. The aggregate supply curve is an upward sloping curve as this direct relation exists between the price and the aggregate amount of goods and services supplied The aggregate demand on the other hand shows the aggregated amount of goods and services demanded at different price levels. The aggregate demand is a decreasing function of the general price level. As the general price level increase less goods and services will be demanded in the cconomy and as price level decrease more quantity of goods and services will be demanded. The aggregate demand curve is a downward sloping curve since the general price level and the aggregate quantity demanded related inversely The intersection of both the AD and AS curve shows the quantity of output produced at a given level of price level and it also shows the level of employmert Shocks in aggregate supply or aggregate demand change the price level and the relative level of GDP and cmployment. A negative shock in aggregate supply shifts the AS curve to the left whereas a positive shocks shift the curve to the right. A negative shock reduces the quantity of aggregate supply and the level of GDP and employment and cause in increase in prices. A positive shocks cause the AS curves to shift to the right causing higher level of GDP and employment with lower price A negative shocks in AD results shift the AD curve to shift to the left and lower national output and employment and lower price level. If the economy is in fullemployment level such a reduction in national demand and the resulting unemployment is termed as recessionary gap. A positive shock in AD shift the curve to the right and cause the aggregate output and employment to increase and the price level to rise. If the economy is already in fullemployment such a situation is termed as inflationary gap 1) An unexpected increase in oil price causes a negative supply shock. Since oil is an input in many of the producing unit, such a sudden unexpected increase in its price increase the cost to produce goods and services which in turn reduce the

profit margin of the firms. This in effect shift the AS curve to shift to the left and the economies output and employment decrease with increased price. The effect of such a negative supply shock on the aggregate output and employment can be illustrated in the following figure AS1 Rotential output Price level AS 120 100 90 AD2 70 AD AD1 18 1920 2 22 Real GDP/Output (Trillions of dollars) Initial equilibrium of the economy is at point 'E with the level of GDP with 20 trillion of dollars. The increase in oil price shift the AS curve from AS to AS1 While aggregate demand remaining constant such a negative supply shocks increase the price level from to 100 to 110. The equilibrium of the economy moves from E to E1. The Real GDP of the economy falls from 20 trillions of dollars to 19 trillions of dollars. The impact of these shocks in the increase in price level, decreasc in real GDP and employment. The cconomy suffers a GDP gap cqual to 20-19 trillion dollars. This situation is known as recessionary gap 2. A stock market crash will cause a negative AD shock. The negative demand shock occurs when there is a fall in the components of AD like consumption, investment, government spending and net export. A stock market crash decreases

the wealth of the people and reduces their consumption. Since consumption is the largest component of AD such a negative shocks reduce the AD to a large extent The AD curve shift to the left causing lower price, output and employment and GDP In the above figure suppose the economy is at fullemployment equilibrium 'E The fall in AD shift this curve down to AD1. While AS remaining at the former level, the fall in AD lowers the GDP and employment and price level. The economy moves from the equilibrium point E to E2 and the GDP fall from 20 trillion to 19 trillion dollars. Here also the cconomy suffers from a GDP cqual to 1 trillion dollars 3. Government spending is another component of AD. An increase in government spending on military service is positive demand shock. Since the economy is already at potential level at E, the increase in money supply created by the increased spending simply add to the price level. The AD curve shift to the right to AD2. The price level increase from initial equilibrium level of 100 to 110. Here also an output gap of 1 trillion dollars. The income of the people increase but there is no corresponding increase in output and employment. This situation is referred to as inflationary gap. The equilibrium of the economy moves to E3 4. Business confidence is one of the components which regulate AS. The lack of incentive on the part of businessmen shifts the aggregate supply curve as early from AS to AS1. Thus the economy will experience increased price, lower output and GDP. This cause a GDP gap of 1 trillion dollars 5. Appreciation in the value of national currency causes export costly and import cheap. This increased import and decreased export cause net fall in export and shift the AD curve to the left from AD to AD1. Then GDP and employment falls and actual output falls short of potential output equal to 1 trillion dollars Policy options. The negative demand shock can be remedied by fiscal and monetary policies. To stimulate more demand the government can use fiscal instrument like decrease in tax and increase in public spending. Again monetary policy is also effective Increase in money supply through monetary instruments like open market operation, lower reserve ratio, lower margin requirements etc are more effective An opposite fiscal and monetary instrument can be used if aggregated expenditure is in excess of potential output

In context of negative supply shock, the fiscal policy is effective. The government can increase the aggregate supply through liberalized tax and subsidies. But monetary policy sufferers from dilemma. In a situation of negative supply shock if the central bank increase money supply aggregate demand wi shift to the right and it will aggravate the inflation. If the central bank tries to control inflation it will aggravate unemployment.