Week 2: Assignment

Your full name: Sidaine Jayden Peters

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Table of Contents
Aggregate Demand and Supply diagram.................................................................................................................3
Effect of Recession Expectations on Aggregate Demand and Economic Output..................................................4
Effect of Rising Foreign Income on Equilibrium Price Level and Real GDP........................................................5
Effect of Foreign price level falls on the equilibrium price level and the real GDP..............................................6
Effect of Increased Government Spending on Equilibrium Price Level and Real GDP.......................................6
Expectation of Workers for High Future Inflation and Its Impact on Equilibrium Price Level and Real GDP 7
How should the Situation be rectified to return to full employment?....................................................................8
Conclusion.................................................................................................................................................................. 9
References.................................................................................................................................................................10

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Aggregate Demand and Supply diagram

The aggregate demand and supply framework is used to analyze the overall performance of an economy
by examining the relationship between total spending and total production. Aggregate supply reflects the
total quantity of goods and services that producers in an economy are willing to supply at different price
levels, often measured through real GDP. Aggregate demand, on the other hand, represents the total
planned expenditure on a nation's goods and services across all sectors (Mankiw, 2021).

Aggregate Demand and Supply Equilibrium

The point where aggregate demand (AD) and aggregate supply (AS) meet is known as the
equilibrium point. This intersection reflects the equilibrium level of real Gross Domestic Product
(GDP) and the overall price level in the economy. The Aggregate Demand, Aggregate supply
diagram can be interpreted from a microeconomic and macroeconomic standpoint. However, the
meanings of the horizontal and vertical axis differ depending on the perspective taken (Lipsey,
R. G., 2010). In a microeconomic context, the vertical axis typically denotes the price, wage, or
rate of return for a particular good or service, while the horizontal axis represents the quantity of
that good or service. From a macroeconomic perspective, the vertical axis reflects the overall
price level such as the GDP deflator or the Consumer Price Index (CPI) and the horizontal axis
indicates real GDP (Farmer, R. E., 2008).

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Effect of Recession Expectations on Aggregate Demand and Economic Output

When consumers and businesses are optimistic about the future, households tend to boost their
consumption, and firms are more willing to increase investment. On the other hand, a decline in
confidence especially when a recession is expected, leads to a reduction in both consumer
spending and business investment. This decline in overall expenditure causes the Aggregate
Demand (AD) curve to shift leftward, resulting in a lower equilibrium price level and a decrease
in real GDP, thereby dampening economic growth (Mankiw, N. G., 2016).

Effect of Recession Expectations on Aggregate Demand and Economic Output

The above graph shows how consumer expectations of a recession lead to a decrease in
aggregate demand, shifting the AD curve to the left. This results in a lower equilibrium output
(Y₂) and price level (P₂), creating a recessionary gap as the economy operates below its
potential. To overcome this issue and restore the economy to full employment, policymakers can
take expansionary measures. These could include greater government expenditure, tax cuts to
boost consumer spending, or monetary measures like interest rate cuts to encourage investment
and borrowing. Such interventions seek to shift the aggregate demand curve to the right,
restoring equilibrium output and price levels.

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Effect of Rising Foreign Income on Equilibrium Price Level and Real GDP

When foreign incomes go up, such as when countries that trade with us grow their economies,
they may buy more goods and services, including exports from the US. When more people want
to buy a country's products, net exports go up. This makes aggregate demand (AD) go up. This is
because net exports, together with consumption, investment, and government spending, represent
a big part of AD.

Aggregate Demand (AD) and Aggregate Supply (AS)

An increase in foreign income leads to increased spending by individuals abroad, which benefits
both their local economy and trading partners such as ours. Because foreign revenue is positively
connected with a country's overall GDP, increased foreign income tends to boost GDP, whilst a
decrease can lower it. This link exists because changes in a country's income have a direct
impact on the volume of imports and exports with its trading partners. As investment increases,
aggregate demand rises, leading the aggregate demand curve to shift to the right. This increases
both the equilibrium price level and overall GDP (Mankiw, 2021).

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Effect of Foreign price level falls on the equilibrium price level and the real GDP

A decline in the foreign price level makes imported goods relatively cheaper compared to
domestically produced goods. As a result, consumers and businesses increase their demand for
imports while foreign demand for domestic exports decreases. This leads to a reduction in net
exports, causing a leftward shift in the aggregate demand (AD) curve. In the short run, this shift
results in a lower equilibrium price level and a decrease in real GDP, as domestic producers face
weaker overall demand and reduce output accordingly.
In the long run, however, as wages and input costs adjust downward, the economy's short-run
aggregate supply (SRAS) curve shifts to the right. This adjustment helps return real GDP to its
full-employment level, although the price level remains permanently lower. Thus, a fall in
foreign prices causes a short-term decline in both output and prices, with a long-term impact of
lower prices and restored output.

Effect of a Shift in Aggregate Demand on Price Level and Real GDP

Effect of Increased Government Spending on Equilibrium Price Level and Real GDP

When the government increases its expenditure, it directly boosts aggregate demand in the
economy. This change in aggregate demand leads the aggregate demand curve to shift to the
right. As a result, in the short run, both equilibrium real GDP and total price levels rise. The
increase in real GDP happens because higher government spending promotes production and
economic activity, resulting in higher output. Simultaneously, increased demand exerts upward
pressure on prices, generating inflation and raising the equilibrium price level. However, if the
economy is already close to full capacity, further government expenditure may result in higher
prices rather than a considerable rise in real output. This process is also aided by the multiplier

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effect, in which initial government expenditure generates new rounds of revenue and spending,
hence raising real GDP. Overall, increasing government expenditure tends to raise both the
equilibrium price level and real GDP in the short term.

Expectation of Workers for High Future Inflation and Its Impact on Equilibrium Price
Level and Real GDP

To keep their purchasing power, workers must earn current salaries. However, higher pay
demands increase the cost of manufacturing for businesses. As a result, corporations may restrict
recruiting or slow expansion when labor costs rise. This results in a decline in short-run
aggregate supply, as indicated by a leftward shift in the aggregate supply curve. The decrease in
aggregate supply leads the equilibrium real GDP to fall, while the total price level rises, leading
to inflation. As a result, the economy sees higher prices yet reduced output, which might slow
economic growth (Cunningham et al., 2010).

Effect of Technological Improvement on Productivity

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Technological improvements play an important role in increasing organizations' productivity.
They boost communication, streamline operations, and foster more collaboration inside
enterprises. Firms using modern technology can perform services more efficiently and respond to
client needs faster, increasing total productivity. This increased productivity is represented in a
shift to the right of the aggregate supply curve. As a result, real GDP rises as firms boost output,
but the aggregate price level declines due to lower production costs. As a result, technical
innovation promotes economic growth and price stability (Rüßmann et al., 2015).

Inflationary Gap
An inflationary gap occurs when aggregate demand exceeds the economy's full employment
output, causing real GDP to rise above its potential level. Excess demand causes enterprises to
temporarily raise production and employment. However, as resources become scarce, input
prices rise, raising overall prices and creating inflationary pressures. The economy cannot keep
output above potential GDP for long without increasing inflation (Blanchard, 2017).

Recessionary Gap
A recessionary gap occurs when an economy's actual output falls short of its potential output,
which is generally caused by lower aggregate demand or supply shocks. This results in decreased
real GDP and falling price levels. Firms respond to lower demand by reducing production and
labor, resulting in increased unemployment and economic decline. The economy is thus
operating below full employment, indicating a recessionary gap (Samuelson & Nordhaus, 2010).

Stagflation
Stagflation occurs when the short-run aggregate supply fluctuates or shifts negatively, causing
unemployment and inflation to rise at the same time. This economic state is distinguished by
slow economic development, higher unemployment rates, and rising prices all at once.
Stagflation is especially difficult because it mixes the problems of inflation and recession,
making standard policy measures less effective (Friedman 1977).

How should the Situation be rectified to return to full employment?

To restore full employment, the economy must reach an equilibrium where the aggregate
demand curve intersects with the aggregate supply curve at the potential level of real GDP. Full
employment is achieved when all available labor and capital resources are utilized efficiently,
and the output equals the economy’s potential GDP. Policies aimed at increasing aggregate
supply—such as supply-side reforms, improving labor market flexibility, and enhancing
productivity—are essential to shift the aggregate supply curve rightward. Additionally, demand-
side policies may be needed to balance aggregate demand, ensuring that output and employment
return to sustainable levels (Blanchard & Johnson, 2013).

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Conclusion

Week 2’s assignment highlights how changes in aggregate demand (AD) and aggregate supply
(AS) affect price levels and real GDP. Recessionary gaps call for expansionary policies, while
inflationary gaps require contractionary measures. Stagflation needs supply-side reforms and
careful demand management. External factors like technology and global conditions also
influence outcomes. Targeted fiscal and monetary policies help restore full employment and
price stability, making the AD-AS model essential for addressing economic issues.

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References

Blanchard, O., & Johnson, D. R. (2017). Macroeconomics (7th ed.). Pearson.

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OECD. (2020). Economic Outlook, Volume 2020 Issue 1. OECD Publishing.
Samuelson, P. A., & Nordhaus, W. D. (2010). Economics (19th ed.). McGraw-Hill Education.

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