Macro Chapter 4 ASAD

Question 1

Give one reason why the aggragate demand curve is downward sloping.

Answer 1

1. Wealth effect : as many of the assets in the economy are denominated in monial values, the higher the price level, the lower the purchasing power of money. This reduces the wealth of the economy. As a result, households and firms reduce their purchases of all goods and services and the real output drops.
2. Interest rate effect : As the price level rises, households and firms demand more money to finance their transactions, Given the fixed supply of money, the interest rate would rise. An increase in interest rate would cause decline in investment and consumption and also the real output

Question 2

Give one reason why the short run aggregate supply curve is upward sloping.

Answer 2

When the price level increases, since input prices are inflexible, output prices increases at a faster pace than input prices. Since the real production cost decreases, firms would employ more factor inputs to produce more output, leading to an increase in real output supplied.

Question 3

Explain how market forces can restore the output level to the potential level when there is an inflationary gap.

Answer 3

When there is an inflationary gap, the excess demand in the factor market will put upward pressure on factor prices. In long run, the upward adjustment of factor prices will lead to an increase in production costs. As a result, short run aggregate supply will decrease, leading to an increase in price level and a decrease in real output, restoring the full employment level.

Question 4

Explain how market forces can restore the output level to the potential level when there is an deflationary gap.

Answer 4

When there is an deflationary gap, the excess supply in the factor market will put downward pressure on factor prices. In long run, the downward adjustment of factor prices will lead to an decrease in production costs. As a result, short run aggregate supply will increase, leading to an decrease in price level and a increase in real output, restoring the full employment level.

Question 5

Explain how an increase in aggregate demand affect the a