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Aggregate demand and supply

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Aggregate demand and supply

Observation

Period 1973-1974

The short-run supply curve in the first period shifts to the left. Inflation that took place resulted in an increase in input prices; the sharp rise in prices reduced the demand and thus adversely reducing supply causing adverse supply shock in the economy.  The reduction in supply, in turn, increased unemployment above the natural rate of 4.5% to 13%.

Present

The aggregate demand curve in the second-period shifts to the left, in the long run, signifying a reduction in aggregate demand in the country. The decrease in demand in the economy results in an increase in unemployment to 9% above the natural rate of 4.5% and a drop in inflation to 0.4%.

Explanation of the first period

The quantity goods and services produced in a country are usually flexible in the long-run supply curve given that prices and wages are adjustable too. At full employment rate, the long-run supply curve is vertical, and the unemployment level equals the natural unemployment rate showing that the economy is operating efficiently. The figure below can be used to explain further the changes in the economy of Macropoland. Inflation increases the price of inputs used in production; thus, the prices increase form PO to P1. Ata P1the supply curve shifts to SRASO to SRAS1 (Rao, 2016). At SRA1, the supply output in the economy is reduced; thus, the country experiences adverse supply shock. Consequently, the demand for labor supply also is reduced, resulting in an increase in the rate of unemployment above the natural rate in the long run. The economy operates efficiently at Y0, representing the natural unemployment rate of 4.5% when the LRAS is vertical. The shift in supply increases the unemployment rate from Y0 to Y1(13%)

Figure 1

Explanation of the second period

Sluggish consumption and investment that is being experienced in the country at this period affect the demand. Conversely, the total demand in the country drops; thus, the aggregate demand in the country shifts to the left. Figure 2 below can be used to further understand the happenings in the economy of Macropoland during this second period. When consumption drops, the demand curve shifts from AD0 to AD1 (Rao, 2016). There is a significant decline in inflation as prices drop from P0 to P1, explaining why inflation reduces to 0.4%. Consequently, the employment rate also rises above the natural rate of Yn 4.55 to Y1(9%).

Figure 2

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Reference

Rao, B. B. (Ed.). (2016). Aggregate demand and supply: A critique of orthodox macroeconomic modelling. Springer.

 

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