Question

In early 2001 investment spending sharply declined in the United States. In the two months following the September \(11,\) 2001 , attacks on the United States, consumption also declined. Use AD-AS analysis to show the two impacts on real GDP. \lfloor 012.6

Short answer

The declines in investment and consumption reduced real GDP through leftward shifts in AD.

Step-by-step solution

Understanding AD-AS Model

The Aggregate Demand-Aggregate Supply (AD-AS) model is used in macroeconomics to represent the total demand and total supply in an economy. In this model, AD represents the total demand for goods and services and AS represents the total supply. The intersection of AD and AS determines the equilibrium real GDP and the price level in the economy.

Initial Decline in Investment Spending

When investment spending declines, it causes a leftward shift in the Aggregate Demand (AD) curve from AD1 to AD2. This happens because with reduced investment, overall expenditure in the economy decreases. This shift results in a lower level of equilibrium real GDP and potentially a lower price level, assuming Aggregate Supply (AS) remains constant.

Subsequent Decline in Consumption Spending

Following the attacks, consumption also declined, causing another leftward shift in the Aggregate Demand curve from AD2 to AD3. This further decrease in consumption reduces total spending in the economy, leading to a further decrease in equilibrium real GDP, while the decrease in the price level may continue.

Aggregate Impact on Real GDP

Overall, the combined effect of reduced investment and consumption leads to a significant leftward shift in the AD curve from its original position (AD1) to its new position (AD3). This results in a cumulative decrease in real GDP and possibly in the general price level, indicating a contraction in the economy.

Key concepts

Aggregate Demand

Aggregate Demand (AD) is a fundamental concept in macroeconomics. It represents the total combined demand for goods and services within an economy at different price levels and time periods. Understanding this concept helps us grasp how various factors impact the economy.

Aggregate Demand encompasses several components, including

• Consumption
• Investment
• Government spending
• Net exports (exports minus imports)

Each component can influence the overall level of demand. When any of these elements change significantly, like how investment and consumption spending declined in 2001, it can cause shifts in the AD curve. A leftward shift in the AD curve indicates a decrease in total demand, which typically results in lower real GDP and price levels. This connection can help predict how certain economic events will affect an economy's output.

Aggregate Supply

Aggregate Supply (AS) is the total supply of goods and services that producers in an economy are willing and able to offer at different price levels over a certain period. The AS curve is crucial for understanding how economic output responds to changes in demand and price levels.

There are two key perspectives to consider with Aggregate Supply:

• Short-run Aggregate Supply (SRAS): In this period, some factors of production are fixed, and prices don't immediately adjust. This curve may be upward sloping due to fixed costs that result in profit changes as prices vary.
• Long-run Aggregate Supply (LRAS): A period where all factors of production can be varied and prices fully adjust. The LRAS curve is vertical, representing potential GDP that the economy can sustainably produce.

While the exercise focused on the AD change, AS's behavior is vital too, as it influences real GDP and the economy's adjustment to new equilibria.

real GDP

Real GDP, or Real Gross Domestic Product, is an economic metric that reflects the value of all goods and services produced by an economy in constant prices. This measure takes into account inflation, providing a clearer picture of an economy's true growth.

The significance of real GDP lies in its ability to show the actual increase in an economy's productivity over time, rather than increases due to price changes. It's a pivotal indicator when assessing economic health. In the context of the AD-AS model, real GDP is determined at the intersection of the Aggregate Demand and Aggregate Supply curves.

In 2001, as both investment and consumption declined, the AD curve shifted leftward. This shift reduced real GDP, signaling a decrease in the economy's output, which often suggests economic contraction.

investment spending

Investment spending is a component of Aggregate Demand that refers to businesses purchasing capital goods. These are items used to produce other goods and services, like equipment and infrastructure. Investment is crucial because it influences economic growth and productivity.

Businesses invest when they expect future growth or returns, which can expand the economy through increased production capacities. However, when investment spending declines, as it did in early 2001, it signals reduced business confidence or market uncertainties. This results in a decrease in total spending, causing an inward shift of the AD curve. Such a shift implies a potential reduction in real GDP, which can lead to slower economic growth or contraction.

consumption spending

Consumption spending involves households purchasing goods and services for everyday use. Representing the largest component of Aggregate Demand, it plays a significant role in determining an economy's health.

Changes in consumption spending can have substantial impacts. If households reduce spending, Aggregate Demand decreases, and this can be caused by factors like declining consumer confidence or economic uncertainty. In the 2001 exercise scenario, consumption spending fell after a national crisis, pushing the AD curve further to the left.

Such a decrease leads to a lower equilibrium real GDP, highlighting how sensitive the economy is to changes in consumer behavior. Understanding this relationship is key to analyzing how shocks to consumption can affect overall economic activity.