The Concepts of Aggregate Demand and Supply - Assignment Example

Economics Student’s Name Institutional Affiliation Question 1 Part (a) The equilibrium output level is determined in the market for goods (IS-curve). On the other hand, interest rate equilibrium is determined in the money market. Changes in the output level in both the money and the goods market will affect the money demand, as well as the equilibrium interest rate. Similarly, the interest rates changes will have an effect on planned investment level coupled the level of the equilibrium output. A fall in the level, in the rate of interest, will not affect the planned investment level provided the investment was not sensitive to the rates of interest. If the Reserve Bank of Australia is concerned about the recession and intends to adopt expansionary monetary policy when the rate of interest is not sensitive to the investment spending, the policy may not be effective. Therefore, the decision to adopt monetary policy will not be an appropriate strategy to stimulate the economy since the fall in the rate of interest did not cause an increase in the planned investment. As a result, there are no perceptible changes in the aggregate output that will have facilitated the effectiveness of the expansionary monetary policy. On the other hand, if the investment level is sensitive to a change in rate of interest, a significant decrease in interest rate level will result into a large increase in the level of investment. Hence, the IS curve will be moderately flat. Therefore, if the RBA adopts an expansionary monetary policy at this time, it will be an appropriate method to affect the level of output and hence the policy will be effective (Young & Zilberfarb 2000). Part (b) If the demand for money is not sensitive to the rates of interest, the LM-curve is usually vertical. This particularly the case when the levels of income are low at the time when people individuals are only using money to make transactions necessary for their survival. If there is an increase in the supply for money, the rates of interest will decrease to 6% and as a result the investment spending increases. Consequently, income, as well as production output will increase the demand for money. This triggers the rise in the interest rates. For example, if the equilibrium rate of interest was 9%, then it will rise to 12%. Thus, monetary policy effectiveness is dependent on the sensitivity of the demand for money to interest changes. If the money demand is perfectly elastic in relation to the rates of interest, a variation in the LM-curve will not have any effect in the rate of interest. However, the more inelastic the money demand is, the larger the fall in the rate of interest from a particular change in the supply for money. Similarly, the bigger the change in the rate of interest, the bigger the larger the prospect for the increase in the aggregate output, thus adoption of the expansionary monetary policy by the Reserve Bank of Australia will be effective (Young & Zilberfarb 2000). Question2 Part a The Solow model indicates that the y=k=n, in a steady state. Besides, the Solow model indicates that the levels of output per person and capital per person rely on saving rate. However, saving rates does not affect the economic growth rate. The actual problem of those people who long to enhance more saving is that the current low saving predicts that the living standard in the future is anticipated to be lower if people save at present moment. Policies to decrease the federal budget deficit may be implemented to encourage saving rate through rewarding saving of households such as offering taxes incentives or embarking to a consumption tax for saving (Burda & Wyplosz 2012). The variation in economic growth is brought by the fluctuations in population growth. If fluctuations in population growth are not consistent with output per person, very few individuals will care as the average standard of people’s living remain unchanged. However, when there is a speed-up or slowdown in output per person, economists, policymakers and public becomes interested in those changes. Therefore, when the economy is in the steady state, capital input, labour input and output are in identical growth rates (Agarwal 2010). In Solow’s model, there is an automatic adjustment of the economy in accordance with steady state output per person (Y/N) AND capital per person (K/N). These automatic adjustment happens when the levels of investment and saving per person does not match with the steady-state investment level per person as may be needed to substitute old capital with new capital to maintain K/N constant given that the growth of the labour force exists. Increase in capital per person, increases the steady-state investment needed. Investment per person depends on the extent of the saving per person. The amount of the saving per person relies on the output per person (Agarwal 2010). Suppose that at the original values of Y/N and K/N, the investment and saving per person go beyond the necessitated steady-state investment per person. Consequently, the values of Y/N and K/N increase. Originally, the rise in saving per person increases the growth rate in Y/N allowing the economy to exceed or meet the increasing the steady-state investment per person as needed by the inclined K/N. However, since the saving per person increases more sluggishly than the steady-state investment per person, increases in K/N that at the end forces all the needed economy’s savings to keep K/N at its present level (Wang 2009). Part (b) If the production function has invariable returns to scale, the real GDP increases with an increase in capital and labour; since inputs and output increases. The ratio of the output to capital, output per person, and capital per person remains relative constant. The real GDP raises to fourfold when labour inputs, capital inputs, and autonomous growth factor double. The capital growth per person relies on the saving rate, the depreciation rates, the output capital ratio and the growth rate of the population. The saving rate is a factor out the four available, which can be affected through policy development. Therefore, the mean saving rate variable becomes the principal policy factor in the determination of growth rate of the economy (Young & Zilberfarb 2000). Question 3 Price stickiness is the propensity of slow adjustment of prices due to changes in the economy. However, Keynes argues that money may neutral and disregards the classical model. Hence, Keynesian uses the concept of price stickiness to demonstrate why the money cannot be neutral. A different version of the model for Keynesian takes an assumption that nominal wages, as opposed to prices are sticky (Hein & Stockhammer 2011). The above aggregate demand function is similar to that of the classical model. The AD-AS represents the interaction between the IS-LM curves in the goods and money market respectively. The SRAS (short-run aggregate supply) curve is in a horizontal position as a result of price stickiness. On the other hand, the LRAS (long-run aggregate supply) curve is in a vertical position. Therefore, the major distinction between the Classical and the Keynesian model is the velocity of adjustment in price. The classical approach has a speedy adjustment in price such that the SRAS curve is extraneous. However, in the Keynesian approach, the curve on short-run aggregate supply is horizontal due to the firms competing monopolistically and facing menu costs (Young & Zilberfarb 2000). The concepts of aggregate demand and supply can be used to demonstrate the economic performance. Aggregate supply is referred to as the total supply of goods and services from the economy of the nation. At higher prices, the aggregate supply is depicted by the upward-sloping graph since firms are motivated to produce more, but they produce less at lower prices. On the other hand, the aggregate demand is referred to as the total amount of goods and services that are demanded in the economy of a nation. The aggregate demand is depicted by the downward-sloping at higher prices as firms, consumers, foreign customers and government are reluctant to buy, while, at lower prices, they are more willing to buy. The graph above displays the aggregate demand and supply. Therefore, shifts in the aggregate demand and aggregate supply curves demonstrate changes in the economy’s performance. Aggregate demand falls as consumer confidence falls and as people decrease their spending. Consequently, there is a real reduction in prices and output forcing the country into a recession. However, when there is too much money supply, there is excessive consumer demand which can force aggregate demand, increasing real prices and output; forcing country into the inflation (Wang 2009). The proposition of the policy-ineffectiveness is commonly misunderstood. It is not in order to say that no government policy influences the economy. Government spending policy represents the changes that the government makes on GDP affecting the employment and output. However, the suggestion is focused on the impacts of changes in the liabilities of the government such as the government debt and the monetary base which affects the inflation rate. Therefore, classical the classical model explains that any anticipated government policy whether fiscal or monetary real implications on the economy, since it is unexpected, then it cannot be efficient and it is appropriate to stimulate the economy (Burda & Wyplosz 2012). References Burda, M. C., & Wyplosz, C. (2012). Macroeconomics. Oxford [u.a.: Oxford Univ. Press. Agarwal, V. (2010). Macroeconomics: Theory and policy. New Delhi: Dorling Kindersley. Wang, P. (2009). The economics of foreign exchange and global finance. Berlin: Springer-Verlag. Hein, E., & Stockhammer, E. (2011). A Modern Guide to Keynesian Macroeconomics and Economic Policies. Cheltenham: Edward Elgar Pub. Young, W., & Zilberfarb, B. (2000). IS-LM and modern macroeconomics. Boston, Mass.; London: Kluwer Academic Publishers. Read More