Question

Suppose workers become pessimistic about their future employment, which causes them to save more and spend less. If the economy is on the intermediate range of the aggregate supply curve, then a. both real GDP and the price level will fall. b. real GDP will fall and the price level will rise. c. real GDP will rise and the price level will fall. d. both real GDP and the price level will rise.

Short answer

When workers become pessimistic about their future employment and save more and spend less, aggregate demand (AD) decreases. This leads to a leftward shift in the AD curve, which intersects the intermediate range of the aggregate supply curve at a lower point. Consequently, both real GDP and the price level will fall. The correct answer is (a).

Step-by-step solution

Understand the impact on aggregate demand

When workers become pessimistic about their future employment, they will save more and spend less. This decrease in consumption will cause a decline in aggregate demand (AD) in the economy.

Analyze the intermediate range of the aggregate supply curve

The aggregate supply curve depicts the relationship between the overall price level and the total output (real GDP) produced by firms within the economy. The intermediate range of the aggregate supply curve represents a period of moderate economic growth, where there is both upward pressure on prices and an increase in the level of output.

Determine the impact on real GDP and price level

Since aggregate demand is decreasing due to workers saving more and spending less, this implies a shift to the left in the aggregate demand curve. When the aggregate demand curve shifts left, it intersects the intermediate range of the aggregate supply curve at a lower point, leading to a decrease in real GDP and a decrease in the price level.

Choose the correct option

Based on our analysis, both real GDP and the price level will fall due to the decrease in aggregate demand. Thus, the correct option is: a. both real GDP and the price level will fall.

Key concepts

Aggregate Demand Decrease

Understanding the effects of a decrease in aggregate demand (AD) is crucial for grasping macroeconomic fluctuations. Aggregate demand is the total amount of goods and services demanded across all levels of an economy at a given overall price level and in a given time period. This includes consumption by the public, investments by industry, government spending, and net export activity.
When consumers, like the workers in our exercise who are worried about their future employment, decide to save more and spend less, there is a direct impact on consumption—one of the pivotal components of aggregate demand. Less spending means lower consumption, which leads to a decrease in aggregate demand.
In an intermediate range of the aggregate supply curve, this decline in AD results in a downward shift of the demand curve on the graph. The immediate effect is that both the real Gross Domestic Product (GDP), which represents the total dollar value of all goods and services produced over a specific time period, and the price level tend to decrease. This is because there's less demand for these goods and services, so their prices fall, and producers may make less of them.

• A decrease in AD typically leads to lower economic output as businesses reduce production in response to less demand.
• Consequently, this can also result in lower prices, as businesses try to attract the reduced number of consumers.

It's this interplay between aggregate demand and supply that helps us understand the ripple effects of consumer behavior on the larger economy.

Economic Growth and Inflation

Economic growth and inflation are intertwined concepts within the landscape of an economy. Economic growth is marked by an increase in the production of goods and services over time, and it is widely measured by changes in real GDP. Positive economic growth is seen as a sign of a healthy economy since it usually leads to higher employment rates and increased standards of living.
However, growth can also lead to inflation, which is the rise in the general price level of goods and services in an economy over a period of time. As the economy grows and consumers have more money to spend, this can increase demand for goods and services, which, in turn, pushes up prices.
In our example, if we were not on the intermediate range of the aggregate supply curve or if AD were not decreasing, high economic growth could lead to inflation. However, because the demand is declining in this scenario, the typical inflationary pressures that accompany economic growth are not present. Instead, we might observe what is known as 'disinflation,' a slowing in the rate of inflation. This occurs as the increase in aggregate supply outpaces the decrease in aggregate demand.

• Inflation is typically associated with economic growth as higher demand leads to higher prices.
• Decreasing AD in a growing economy can mitigate inflationary pressures and lead to disinflation.

Understanding the relationship between economic growth and inflation is essential for policymakers, as they must balance stimulating the economy without causing excessive inflation.

Impact of Consumer Spending on Economy

Consumer spending, or personal consumption, is the largest component of aggregate demand and plays a central role in driving economic activity. When consumers spend more, businesses see increased revenue, which can lead to more hiring and investment in order to meet the higher demand. This positive feedback loop contributes to economic expansion and job creation.
However, as illustrated in our textbook exercise, when consumer confidence drops and spending declines, the ripple effect through the economy can be significant. Businesses will see a fall in sales, which may lead them to cut back on production, reduce their workforce, and decrease investment. Such a situation not only impacts the firm's bottom line but can also dampen economic growth more broadly.
The exercise demonstrates a scenario where increased savings and reduced spending collectively cause a contraction in aggregate demand, leading to a decrease in both real GDP and the price level. Here's the impact in a nutshell:

• Less consumer spending results in decreased business revenue, leading to a potential reduction in the workforce and investment.
• The economy may experience a slowdown as the decrease in spending affects all sectors, creating a cascading effect of lower demand for goods and services.

Therefore, consumer spending is a powerful economic force, and significant changes in this spending can lead to far-reaching impacts across the economy.