Aggregate Supply and Aggregate Demand Model

Aggregate Supply and Aggregate Demand Model

1) Long-run Macroeconomic Equilibrium and Stock Market Boom Let us assume the economy reaches its long-run macroeconomic equilibrium in 2020. When the economy is in the long-run macroeconomic equilibrium, the stock market will also reach its boom. This will in turn lead to increases in stock prices more than expected, and the stock prices will stay high for some period. Answer the following questions based on the scenarios of long macroeconomic equilibrium and consequent stock market boom.

  1. a) Which curve will shift? Is it AS curve or AD curve? In which direction does the shift occur?

The aggregate demand curve will shift the right. When the GDP rises, the AD curve will shift.

  1. b) In the short-run, what will happen to the price level and output (real GDP)?

Since the demand shifts to the right, both the price and output (real GDP) will increase.

  1. c) What will happen to the expected price level? What impact does this have on wage bargaining power of workers?

The expected price level will rise and workers will also increase their bargaining power and demand for better wage.

  1. d) In the long-run, which curve will shift due to the change in price expectations created by the stock market boom? In which direct will it shift?

The short-run aggregate supply curve will shift to the left.

  1. e) How does the new long-run macroeconomic equilibrium differ from the original equilibrium?

They differ since the price level is higher and the real GDP is the same.

2) Studies indicate that net exports and net capital outflows tend to be equal.

  1. a) Why are net exports and net capital outflows tend to be equal? How does an increase in the price level change interest rates?

The net export and net capital outflow are equal because every international transaction is the same. Precisely, the value of goods and services produced in a country is equal to the value of payments of assets made by the buyers to the producers in other countries. Similarly, when buyers in other countries trade their assets, they convert them to equal amount in the country’s currency and use the same amount to cater for their export products (Krugman & Wells, 2009). Interest entails the cost the individual will incur for holding money. Therefore, if an individual expects more money to be devalued, there will be more demand for interest compensation.

  1. b) How does this change in interest rates lead to changes in investment and net exports?

An increase in interest rates due to the increase in price will discourage investment since the rate at which investors will pay back the borrowed amount is high. Similarly, high interest rates reduces the supply of dollars in foreign exchange market (Krugman & Wells, 2009). The dollar will appreciate and this will decrease the net export.

3) Assume there is a decrease in the demand for goods and services, which leads to a decrease in the real GDP and eventually the economy into recession.

  1. a) When the economy enters recession due to a decline in demand, what will happen to the price level?

During a recession individuals tend to save money since they have lost confidence in it; therefore, the low inflation rate is accompanied by a fall in price level.

  1. b) Assume there is no government intervention. What will ensure that the economy still eventually gets back to the natural rate of output (real GDP)?

When the aggregate demand decreases, the price level will eventually fall. If the government does not take any action to counter the situation, the actual price level will fall below people’s expectation. However, people will correct their expectations and the level of prices and wages will adjust shifting the aggregate supply curve to the right. This will cause output to rise back to its natural rate.

4) A number macroeconomic variables decline during recessions. One of these variables is the GDP.

  1. a) What other variables, besides real GDP, tend to decline during recessions? Given the definition of real GDP and its components, explain the declines in these economic variables which are to be expected.

During a recession, the following components tend to decline; investment, employment, sales, income and purchases. In a situation when the economy experiences recession, the value of money decreases and this will result to less investment, income, sales, purchases and employment. The overall result would be a fall in real GDP.

  1. b) Empirical studies indicate that the long-run trend in real GDP of the USA has an upward trend. How is this possible given business cycles and macroeconomic fluctuations? What factors explain the upward trend in spite of the cycles?

The long-run trend in real GDP is upward; however, during recession, the real GDP tends to flatten. Therefore, when the U.S. economy experienced expansion and recession, the general trend of real GDP increased. The factor that might cause an upward trend in spite of the business cycles is war. The U.S. economy experienced average expansion that lasted for fifty eight months and average recession that lasted for eleven months during the post-World War II period. Similarly, the 2001 recession lasted for eight months hence it was slightly shorter than the average recession. The longest recession was between 2007 and 2009 and it lasted for eighteen months.

5) Assume there are short-run and long-run Macroeconomic Equilibriums in the economy.

Refer to the AS and AD curves above to answer the following questions.

  1. a) What is the initial point of the long-run macroeconomic equilibrium? What are the equilibrium values? What does the appearance of the long-run aggregate-supply (LRAS) curve indicate? How does it differ from AS?

The initial long-run macroeconomic equilibrium is at point A. The equilibrium price is P1 and equilibrium output is Y1. The long-run aggregate supply curve indicates that the GDP reaches full employment and the natural rate of output is the equilibrium price. The AS curve is in equilibrium with the AD and the long-run supply curve.

  1. b) What are the factors that can shift short-run aggregate supply curve from AS1 to AS2? What does Point A represent in the graph? What does point B represent? Is it the short-run or long-run macroeconomic equilibrium? Explain.

The factors that can cause the short-run supply curve to shift to the right include changes in the capital stock, level of technology and changes in the prices of factors of production. Other factors include a rise in inflation and changes in the stock of natural resources. Point A represents long-run macroeconomic equilibrium. This is because the economy reaches a long-run equilibrium at a point where the aggregate demand curve intersects the long-run aggregate supply curve (Moffatt, 2012). At point B, the economy is at short-run macroeconomic equilibrium. Therefore, at point B, the aggregate demand curve intersects the short-run aggregate supply curve.

  1. c) Assume aggregate demand (AD) is held constant, in the long-run, starting from point B, what will the economy likely experience? Will it reach the long equilibrium?

The economy will experience a rising price level and a decreasing level of output in the long-run. Similarly, the economy will not reach long-run equilibrium because it occurs at the point of intersection between the aggregate demand curve and the long-run aggregate supply curve.




Krugman, P., & Wells, R. (2009). Macroeconomics. New York, N.Y.: Worth Publishers.

Moffatt, M. (2012). Short-run vs. Long-run. Retrieved from







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