EMBA 1ST SEMESTER

BUSINESS ECONOMICS - ECO400

ASSIGNMENT # 03

SUBMITTED TO: Ms. SAIRA HABIB

SUBMITTED BY: MUHAMMAD USMAN
REG. NO: SP15-EMBA-290
EMAIL : sp15emba290@vcomsats.edu.pk
DATED: 07-06-2014

Q.1
The basic model of aggregate demand and aggregate
supply
Economists use the model of aggregate demand and aggregate supply to explain short run
fluctuations in economic activity around its long run trend.
The aggregate-demand curve shows the quantity of goods and services that households,
firms, and the government want to buy at each price level.
The aggregate-supply curve shows the quantity of goods and services that firms choose
to produce and sell at each price level.

The vertical axis represents the price level of all final goods and services. The aggregate price
level is measured by either the GDP deflator or the CPI. The horizontal axis represents the real
quantity of all goods and services purchased as measured by the level of real GDP. Notice that
the aggregate demand curve, AD, like the demand curves for individual goods, is downward
sloping, implying that there is an inverse relationship between the price level and the quantity
demanded of real GDP.
Aggregate Demand and Aggregate Supply

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The four components of GDP (Y) contribute to the aggregate demand for goods and services.
Y = C + I + G + NX

As the prices of goods and services are decreased, there is an increase in the quantity of the
goods and services demanded. The below figure depicts the fact;

Changes in aggregate demand

Changes in aggregate demand are represented by shifts of the aggregate demand curve. An
illustration of the two ways in which the aggregate demand curve can shift is provided in Figure.

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A shift to the right of the aggregate demand curve from AD 1 to AD 2 means that at the same
price level the quantity demanded of real GDP has increased. A shift to the left of the aggregate
demand curve, from AD 1 to AD 3, means that at the same price levels the quantity demanded of
real GDP has decreased.
Changes in aggregate demand are not caused by changes in the price level. Instead, they are
caused by changes in the demand for any of the components of real GDP, changes in the demand
for consumption goods and services, changes in investment spending, changes in the
government's demand for goods and services, or changes in the demand for net exports.
Consider several examples. Suppose consumers were to decrease their spending on all goods and
services, perhaps as a result of a recession. Then, the aggregate demand curve would shift to the
left. Suppose interest rates were to fall so that investors increased their investment spending; the
aggregate demand curve would shift to the right. If government were to cut spending to reduce a
budget deficit, the aggregate demand curve would shift to the left. If the incomes of foreigners
were to rise, enabling them to demand more domestic made goods, net exports would increase,
and aggregate demand would shift to the right. These are just a few of the many possible ways
the aggregate demand curve may shift. None of these explanations, however, has anything to do
with changes in the price level.

Reasons for a downwardsloping aggregate demand curve

Three reasons cause the aggregate demand curve to be downward sloping

1. Price Level and Consumption: The Wealth Effect

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A decrease in the price level makes consumers feel wealthier, which in turn encourages them
to spend more. The wealth effect, therefore, provides one reason for the inverse relationship
between the price level and real GDP that is reflected in the downwardsloping demand curve
2. Price Level and Investment: Interest Rate Effect
A lower price level reduces the interest rate. How? Lower prices reduce the amount of
money people want to hold. As a result of falling IR, investment spending increases.
As the interest rate rises, spending that is sensitive to rate of interest will decline. Hence, the
interest rate effect provides another reason for the inverse relationship between the price level
and the demand for real GDP. The increased demand for a fixed supply of money causes the
price of money, the interest rate, to rise.
3. Price Level and Net Exports: Exchange-Rate Effect
When a fall in the U.S. price level causes U.S. interest rates to fall, the real exchange rate
depreciates, which stimulates U.S. net exports. As the domestic price level rises, foreign
goods become relatively cheaper so that the demand for imports increases. However, the rise
in the domestic price level also means that domestic goods are relatively more expensive to
foreign buyers so that the demand for exports decreases. When exports decrease and imports
increase, net exports (exports imports) decrease. Because net exports are a component of real
GDP, the demand for real GDP declines as net exports decline.

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