Aggregate Demand & Aggregate Supply Practice Question

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Aggregate Demand & Aggregate Supply Practice Question

A typical first-year college textbook with a Keynesian bent may as a question on aggregate demand and aggregate supply such as:

Use an aggregate demand and aggregate supply diagram to illustrate and explain how each of the following will affect the equilibrium price level and real GDP:

  1. Consumers expect a recession
  2. Foreign income rises
  3. Foreign price levels fall
  4. Government spending increases
  5. Workers expect high future inflation and negotiate higher wages now
  6. Technological improvements increase productivity

We will answer each of these questions step-by-step. First, however, we need to set up what an aggregate demand and aggregate supply diagram looks like. We will do that in the next section.

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Aggregate Demand & Aggregate Supply Practice Question - Set-Up

Aggregate Demand & Supply 1
Aggregate Demand & Supply 1.

This framework is quite similar to a supply and demand framework, but with the following changes:

  • Downward sloping demand curve becomes aggregate demand curve
  • Upward sloping supply curve becomes aggregate supply curve
  • Instead of "price" on the Y-axis, we have "price-level".
  • Instead of "quantity" on the X-axis, we have "Real GDP", a measure of the size of the economy.

We will use the diagram below as a base case and show how events in the economy influence the price level and Real GDP.

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Aggregate Demand & Aggregate Supply Practice Question - Part 1

Aggregate Demand & Supply 2
Aggregate Demand & Supply 2.

Use an aggregate demand and aggregate supply diagram to illustrate and explain how each of the following will affect the equilibrium price level and real GDP:

Consumers Expect a Re​cession

If the consumer expects a recession then they will not spend as much money today as to "save for a rainy day". Thus if spending has decreased, then our aggregate demand must decrease. An aggregate demand decrease is shown as a shift to the left of the aggregate demand curve, as shown below. Note that this has caused both Real GDP to decrease as well as the price level. Thus expectations of future recessions act to lower economic growth and are deflationary in nature.

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Aggregate Demand & Aggregate Supply Practice Question - Part 2

Aggregate Demand & Supply 3
Aggregate Demand & Supply 3.

Use an aggregate demand and aggregate supply diagram to illustrate and explain how each of the following will affect the equilibrium price level and real GDP:

Foreign Income Rises

If foreign income rises, then we would expect that foreigners would spend more money - both in their home country and in ours. Thus we should see a rise in foreign spending and exports, which raises the aggregate demand curve. This is shown in our diagram as a shift to the right. This shift in the aggregate demand curve causes Real GDP to rise as well as the price level.

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Aggregate Demand & Aggregate Supply Practice Question - Part 3

Aggregate Demand & Supply 2
Aggregate Demand & Supply 2.

Use an aggregate demand and aggregate supply diagram to illustrate and explain how each of the following will affect the equilibrium price level and real GDP:

Foreign Price Levels Fall

If foreign price levels fall, then foreign goods become cheaper. We should expect that consumers in our country are now more likely to buy foreign goods and less likely to buy domestic made products. Thus the aggregate demand curve must fall, which is shown as a shift to the left. Note that a fall in foreign price levels also causes a fall in domestic price levels (as shown) as well as a fall in Real GDP, according to this Keynesian framework.

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Aggregate Demand & Aggregate Supply Practice Question - Part 4

Aggregate Demand & Supply 3
Aggregate Demand & Supply 3.

Use an aggregate demand and aggregate supply diagram to illustrate and explain how each of the following will affect the equilibrium price level and real GDP:

Government Spending Increases

This is where the Keynesian framework differs radically from others. Under this framework, this increase in government spending is an increase in aggregate demand, as the government is now demanding more goods and services. So we should see Real GDP rise as well as the price level.

This is generally all that is expected in a 1st-year college answer. There are larger issues here, though, such as how is the government paying for these expenditures (higher taxes? deficit spending?) and how much government spending chases away private spending. Both those are issues typically beyond the scope of a question such as this.

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Aggregate Demand & Aggregate Supply Practice Question - Part 5

Aggregate Demand & Supply 4
Aggregate Demand & Supply 4.

Use an aggregate demand and aggregate supply diagram to illustrate and explain how each of the following will affect the equilibrium price level and real GDP:

Workers Expect High Future Inflation and Negotiate Higher Wages Now

If the cost of hiring workers has gone up, then companies will not want to hire as many workers. Thus we should expect to see the aggregate supply shrink, which is shown as a shift to the left. When the aggregate supply gets smaller, we see a reduction in Real GDP as well as an increase in the price level. Note that the expectation of future inflation has caused the price level to increase today. Thus if consumers expect inflation tomorrow, they will end up seeing it today.

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Aggregate Demand & Aggregate Supply Practice Question - Part 6

Aggregate Demand & Supply 5
Aggregate Demand & Supply 5.

Use an aggregate demand and aggregate supply diagram to illustrate and explain how each of the following will affect the equilibrium price level and real GDP:

Technological Improvements Increase Productivity

A rise in firm productivity is shown as a shift of the aggregate supply curve to the right. Not surprisingly, this causes a rise in Real GDP. Note that it also causes a fall in the price level.

Now you should be able to answer aggregate supply and aggregate demand questions on a test or exam. Good luck!