Exercises: Aggregate demand and aggregate supply

Explain what an economy's aggregate demand is and name its four components, giving an example of each.

Explain what aggregate supply is and mention two factors that can increase it. How does it relate to firms' production costs?

The figure shows the aggregate demand and aggregate supply curves of an imaginary country.

1. a) Read the equilibrium price level and output from the graph.
2. b) Explain in your own words what this macroeconomic equilibrium point means.

Aggregate demand has four components: household consumption, firms' investment, public spending and net exports (exports minus imports). Classify each case: a household buys a car, a firm buys robots, the government builds a health centre and a country sells oranges abroad.

Explain what aggregate supply is and why, in the short run, it is usually drawn with a positive slope: if the prices firms can charge rise faster than their costs, what incentive do they have to produce?

Compare the supply and demand model of a single market (for example, strawberries) with the AD-AS model of a whole country: what does each axis measure in each case (the price of one good versus the general price level, the quantity of one good versus GDP)?

What does macroeconomic equilibrium mean? Explain what it means for an economy to be producing "below its potential": which resources are going to waste and how is that noticeable in real life?

Classify these events as demand shocks or supply shocks: a wave of optimism that sends business investment soaring, an earthquake that destroys factories, an increase in public spending on roads and a worldwide rise in the price of gas.

Households in a country, optimistic about the future, increase their consumption.

1. a) Which curve shifts and in which direction?
2. b) Explain what happens to the equilibrium output and price level.

The price of oil doubles, driving up transport and manufacturing costs across the country.

1. a) Which curve is affected and why?
2. b) Analyse the new equilibrium: what happens to output and prices, and what problem does this combination of effects pose?

Explain the difference between a movement along the aggregate demand curve and a shift of the curve itself. Give an example of a cause for each case.

Irish exports of tourism services break records two years in a row.

1. a) Which component of aggregate demand increases and which way does the curve shift?
2. b) Explain the effect on the equilibrium output and price level.
3. c) Reason what difference it makes if the economy has high unemployment or is already close to its maximum capacity.

The international price of gas falls by half and transport and electricity become cheaper across the country.

1. a) Which curve shifts and in which direction? Justify it using production costs.
2. b) Explain why this shock is "doubly good news" for the equilibrium (output and prices).

An economy has these annual figures, in billions of euros: consumption $600$, investment $150$, public spending $250$, exports $200$ and imports $220$.

1. a) Calculate the country's aggregate demand (and, with it, GDP) by adding the components.
2. b) What sign does the foreign balance have and what does it mean for the country's demand?

In the middle of a recession, a government cuts public spending to reduce the deficit.

1. a) Analyse the effect on aggregate demand and on the equilibrium (output and employment) using the AD-AS model.
2. b) Set out the argument of those who defend the cut (market confidence, debt sustainability) and of those who criticise it (making the recession worse). What does it depend on for one side or the other to be right?

A recession caused by a lack of demand and a recession caused by a supply shock do not have the same symptoms or the same remedies.

1. a) Explain what happens to prices in each type of recession (they fall or level off versus they rise while output falls).
2. b) Reason why stimulating demand can be a good remedy in one case and counterproductive in the other.

A coastal region of Ireland experiences an intense tourism “boom”: the arrival of foreign visitors doubles in one year, driving up spending on hospitality, transport, and leisure. At the same time, hotels and restaurants expand their facilities and hire thousands of additional workers.

1. a) Graph and explain using the AD-AS model the short-term impact on regional GDP and the general price level. Accurately identify which specific components of aggregate demand have been affected.
2. b) In the medium term, shortages of labor and housing push up required wages and commercial rents throughout the region. Predict how this cost reaction will affect regional aggregate supply and the final macroeconomic equilibrium.
3. c) Design a policy intervention for the Government to mitigate the risk of overheating and inflation without destroying the employment generated. Justify the pros and cons of your proposal.

Following the collapse of several banking institutions, economic confidence plummets: households increase their savings rate from 6 % to 15 % of their income as a precautionary measure due to fear of unemployment, while firms cancel 30 % of their planned investment projects.

1. a) Represent the shock in the AD-AS model and explain the resulting recession. Justify how the individual, prudent behaviour of each household ("saving more during a crisis") ends up collectively causing a drop in sales, more layoffs, and lower aggregate income (the paradox of thrift).
2. b) A business association proposes reducing wages by 10 % as a solution to cut costs so that firms start hiring again. Critically evaluate this proposal: what effect would it have on aggregate supply and what effect on aggregate demand? Would it help exit the recession or worsen the downward spiral of consumption? Justify your answer.

A pundit firmly states: "All economic growth is always accompanied by inflation; it is impossible for a country to increase its GDP while keeping prices stable or falling."

1. a) Use the AD-AS model to refute this statement. Graphically represent and compare two different ways an economy can grow by 3 % in GDP: one based on an expansionary aggregate demand shock and another based on an expansionary aggregate supply shock. Explain what happens to the price level in each case.
2. b) Assume that the country competes fiercely in international markets with industrial goods. Justify which of the two growth paths strengthens external competitiveness and the real purchasing power of wages more in the long run, and explain what economic policy measures foster this type of growth.

The Government announces a major public works plan in the same year that the Central Bank raises interest rates to curb inflation.

1. a) Analyse the effect of each measure separately on aggregate demand.
2. b) Explain why the combined effect is ambiguous: what does the final result depend on (the size of each measure, how sensitive investment is to interest rates)?
3. c) What indicators would you watch during the year to know which effect is dominating?

Two countries apply the same demand stimulus. The first has $15\ \%$ unemployment and factories running at half capacity; the second is close to full employment.

1. a) Predict the effect on each country's output and justify it with the AD-AS model.
2. b) What will happen to prices in each one? What shape does the aggregate supply curve have near full employment and what does that imply?
3. c) Draw the lesson for the design of stimulus measures: when do they work and when do they only heat up prices?

An economy experiences a recession in the first quarter of the year due to a collapse in exports. Official national accounting statistics take five months to confirm the drop in GDP, and Parliament takes another four months to approve an extraordinary public works plan. The works begin execution twelve months after the crisis, just when the economy has already begun to recover autonomously.

1. a) Use the AD-AS model to illustrate the situation: show the equilibrium during the recession and predict what will happen to output and inflation if the massive fiscal stimulus takes effect when the economy was already operating close to its potential level.
2. b) Identify and classify in this case study the different types of time lags (recognition, decision, execution, and impact) that have affected fiscal policy.
3. c) In light of this problem, design two fiscal policy mechanisms (automatic stabilisers) that act immediately without the need for Parliament to pass a law in each crisis. Explain how they cushion fluctuations in aggregate demand.

A country shows these data (GDP is real, at constant year-$1$ prices): year $1$: GDP $500$ and price level $100$; year $2$: GDP $515$ and prices $103$; year $3$: GDP $508$ and prices $109$.

1. a) Interpret the evolution: what happens in year $2$ and what changes in year $3$?
2. b) Formulate a hypothesis about which shocks (demand or supply) explain each stretch.
3. c) As an economic adviser, what would worry you most at the end of year $3$ and what policy would you consider? Reason through the dilemma.

A student argues: "The aggregate demand curve is downward-sloping for the same reason as the individual demand for a good: if prices rise, consumers substitute that good for a cheaper one and buy less."

1. a) Refute the student's statement by demonstrating why it commits a "fallacy of composition": why does the microeconomic substitution effect between goods not explain the downward slope of aggregate demand when the general price level ($P$) rises?
2. b) Analytically justify the three real macroeconomic effects that explain why a rise in the general price level reduces total spending in an economy (the wealth effect, the interest rate effect, and the net exports effect).
3. c) If the prices of all goods and the wages of all workers rose by exactly 10 % at the same time, would real output change in the long run? Reason your answer by distinguishing between nominal variables and real variables in the AD-AS model.