Aggregate Economy

Question 1

Why is the AD sloped from left to right

Answer 1

Real balance effect —> price level rises so consumers have less purchasing power so consumer expenditure falls
Trade effect —> domestic price is higher than other countries then export expenditure falls, imported goods seem cheaper compared to higher domestic price level so X-M falls

Question 2

Why is the AS shaped like a L curve

Answer 2

Low output —> elastic supply, no shortage of FoP, firms can employ more factors without increasing unit costs, output can increase without increasing price level because of spare capacity
Approaching full employment level output —> difficulties occur in acquiring extra resources to increase supply so firms unit costs increase, shortages of FoP appear so firms increase their price to cover this
Full employment level of output —> capacity cannot expand beyond this level, output cannot increase either

Question 3

Why do prices increase when approaching full employment level of output

Answer 3

Firms cannot expand output as fast as demand is rising
Extra resources are more difficult to get hold of —> consumers bid up prices in an attempt to fulfill their demand and firms will raise prices to cover the cost of extra resources