Name: Ahsan Irfan
ERP: 25928
Class No: 70281
Assignment # 5
Teacher: Dr Ateeb
Q1
a) The aggregate demand curve shows the quantity of products and services that the economy
demands at different levels of price. An increase in consumer confidence results in higher
consumption at different price levels. The aggregate demand curve is shifted to the right by this
increased consumption. A rise in consumer confidence indicates that consumers like the product
and are willing to purchase more of it. The demand at that price rises as the customer requests
more, increasing the overall demand and shifting the curve to the right. The equilibrium output
and equilibrium price level of the good or service will similarly grow as a result of the AD curve's
shift to the right.
b) When the government reduces the income taxes, it means that people will be giving out a lesser
part of their income to the government in the form of taxes. It will increase the amount of
disposable income, that is income available to spend with the consumers. The higher amount of
disposable income will lead to consumers spending more of their money and asking for more
products and services. This increase in demand will also increase the aggregate demand and the
AD curve will shift outwards or rightwards.
Q2
a) The inflation target rate is increased by the Fed.
It is widely known that, over the long run, the expansion
of the money supply is the primary determinant of inflation.
We are aware that the FED determines the total amount
of reserves in the banking system using open market transactions.
Bonds are purchased by FED banks through open market
transactions. This is an illustration of expansionary monetary policy.
We depict the supply curve as a vertical line since the federal
bank determines the amount of reserves, which is based
on Fed monetary policy.
b) Oil prices drop sharply.
Even though sharp decline is good news for oil importers, it is bad news for oil exporters such as
Iraq, Venezuela.
The effect of oil price shock on aggregate supply is a mere impact than a simple rise in the cost
of output. If oil prices decline it ultimately helps to reduce the cost of living. Which is primarily
caused due to oil-related transport costs.
This shows that a fall in oil prices will shift the short-run aggregate supply to the right and
thereby increases the real GDP.
Q3.
As inflation increases, the aggregate demand curve shifts into the inflationary portion of the
aggregate supply curve, where consumer demand for goods and services has risen above firms'
capacity to satisfy it. As shown in the diagram below
As a result of increase in inflation level, the value of dollar depreciates leading to higher prices
for exported goods and hence a decrease in exports as consumers abroad will substitute their
consumer goods for low priced alternatives produced within their country.
Q4
Here in diagram, economy will move to above the full employments after the 18 months. since
economic conditions would not be same over the 18 months. So policy might not produce desirable
impacts on the economy.
Q5
a) Permanent increase in oil prices is a permanent supply shock. SRAS shifts upwards leading to a rise in
prices. LRAS also shifts lefts as the shock is permanent, it leads to fall in potential output. Since there is
no stabilizing policy the short run impact is an increase in price level and fall in output.
b) In the long run also, SRAS shifts upwards and LRAS shifts left. When there is stabilizing policy of
tightening monetary policy, money supply decreases, AD shifts left. This controls the inflation, but
output is at a permanently lower level.
Q6
a) Benefit - Output increases and unemployment falls
Cost - Rate of inflation increases.
b) Benefit - in long-run equilibrium, the economy will be at potential output with a lower rate of
inflation.
Cost – in short-run equilibrium, the economy will be at recessionary gap with a higher
unemployment rate
Q7
a) A decline in the consumer spending will shift the Aggregate demand curve of the economy
leftwards to AD1 due to decline in consumption expenditure.
b) as the diagram depicts the short run equilibrium of the economy, the SRAS will shift from point
E1 to E2 and thus both output and prices will in the short run
c) i) An adverse inflation shock in the economy will shift the SRAS curve to SRAS1 and this will
reduce the output level further Y3
ii) In this case, in order to stabilize the economy, expansionary fiscal policy should be followed
by government which will shift the AD1 curve rightwards to AD2 and new equilibrium can be
restored at point E4 where output is at the natural level
Q8
False. Although the economy does have some self-correcting mechanisms that can aid in its return to
equilibrium, depending exclusively on these mechanisms may not be sufficient to guarantee steady
economic growth. One such mechanism that can assist in restoring the economy to its potential
production level is the market's capacity to modify prices and wages in response to shifts in supply and
demand. Long-term advancements in productivity and technology can also support increased economic
growth and lower unemployment.
The self-correcting mechanisms of the economy do, however, have some limitations. First of all, it may
take some time for these adjustments to take hold, resulting in extended stretches of high
unemployment and slow development before the economy self-corrects. Second, due to market
imperfections such externalities, monopolies, and information asymmetry, which can hinder markets
from producing efficient results, self-correction mechanisms might not always function as intended.
Finally, economic shocks may be too severe for self-correction mechanisms to handle on their own,
which can result in recessions and protracted periods of economic stagnation. Therefore, making active
use of stabilization measures like fiscal and monetary policy can aid in reducing economic turbulence
and promoting steady growth.