Question

What effects would each of the following have on aggregate demand or aggregate supply, other things equal? In each case, use a diagram to show the expected effects on the equilibrium price level and the level of real output, assuming that the price level is flexible both upward and downward.

1. A widespread fear by consumers of an impending economic depression.

2. A new national tax on producers based on the value added between the costs of the inputs and the revenue received from their output.

3. A reduction in interest rates.

4. A major increase in spending for health care by the federal government.

5. The general expectation of coming rapid inflation.

6. The complete disintegration of OPEC, causing oil prices to fall by one-half.

7. A 10 percent across-the-board reduction in personal income tax rates.

8. A sizable increase in labor productivity (with no change in nominal wages).

9. A 12 percent increase in nominal wages (with no change in productivity).

10. An increase in exports that exceeds an increase in imports (not due to tariffs).

Short answer

1. It will decrease the aggregate demand.

2. It will decrease the aggregate supply.

3. It will increase aggregate demand.

4. It will increase the aggregate demand.

5. It will increase the aggregate demand.

6. It will increase the aggregate supply.

7. It will increase the aggregate demand.

8. It will increase the aggregate supply.

9. It will decrease the aggregate supply.

10. It will increase the aggregate demand.

Step-by-step solution

Explanation for part (a)

The fear of impending economic depression among consumers will motivate them to save more. Thus, the consumption expenditure will decline.

Therefore, the aggregate demand will decline, and the demand curve will shift to the left (AD’). As a result, output and prices will decrease from Y to Y’ and P to P’, respectively.

Explanation for part (b)

Due to higher costs, increased taxes on producers will decrease the aggregate supply from AS to AS’.

Therefore, the real output will decline from Y to Y’, and the price will increase from P to P’.

Explanation for part (c)

Interest rates and investment have an inverse relationship. As the interest rate declines, the investment will rise as the cost for borrowing is reduced. Therefore, the aggregate demand will increase.

Thus, the AD curve will shift from AD to AD’, and prices and real output will move up to P’ and O’, respectively.

Explanation for part (d)

An investment in government spending will raise the aggregate demand.

Therefore, the AD curve will shift to the right, and output will reach Y’ while the price will change to a higher P’.

Explanation for part (e)

Expected inflation shortly will motivate the households to increase their consumption. So the increased private consumption will increase the aggregate demand.

As a result, the AD curve will shift to the right, increasing the output and prices to Y’ and P’, respectively.

Explanation for part (f)

A reduction in oil prices will increase the aggregate supply in the U.S. because the availability of the imported raw material (crude oil) will rise due to lower costs.

Thus, the AS curve will shift to the right (AS’). And prices will fall to P’ while the real output will increase to Y’.

Explanation for part (g)

A reduction in personal income taxes will increase the disposable income of the consumers. By the consumption function, the private consumption of the economy will improve.

Thus, the aggregate demand curve will move to the right, increasing the real output and prices as shown in the above graph.

Explanation for part (h)

An increase in productivity at constant nominal wages will increase the aggregate supply because labor becomes cheaper and efficient.

Hence, the aggregate supply curve will shift to the right, and real output will increase to Y’ while prices will decrease to P’.

Explanation for part (i)

As the nominal wages increase without any change in productivity, the result will be expensive and inefficient labor. Thus, the aggregate supply will decrease.

Hence, the AS curve will shift from AS to the left (AS’), causing a decline in output by YY’ and an increase in prices by (PP’).

Explanation for part (j)

As the net exports increase, the aggregate demand will increase, causing a

a rightward shift in the AD curve.

Hence, the AD curve shifts to AD’, causing an increase in output and prices to Y’ and P’, respectively.