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Describe how the following changes affect the aggregate demand (AD) curve. Your ...

May 4, 2024

Describe how the following changes affect the aggregate demand (AD) curve. Your answer must state clearly which component of the aggregate demand is affected and how AD curve eventually shifts. (i) Firms are pessimistic about the future sales. (2 marks) (ii) The government has announced a reduction in personal taxes. (2 marks) (iii) The currency of a country depreciates against major trading partners. (2 marks) (iv) The central bank cuts interest rates to boost market sentiment. (2 marks)

i Solution

Impact on Investment Component: When firms are pessimistic about future sales, they are likely to reduce investment spending

Shift of AD Curve: A decrease in investment spending will cause the aggregate demand curve to shift to the left

i Answer

The aggregate demand curve will shift to the left due to a decrease in investment spending caused by firms' pessimism about future sales.

Key Concept

Investment Component of AD

Explanation

Firms' pessimism about future sales leads to reduced investment, which decreases aggregate demand.

ii Solution

Impact on Consumption Component: A reduction in personal taxes increases disposable income, which can lead to an increase in consumer spending

Shift of AD Curve: An increase in consumer spending will cause the aggregate demand curve to shift to the right

ii Answer

The aggregate demand curve will shift to the right due to an increase in consumer spending following a reduction in personal taxes.

Key Concept

Consumption Component of AD

Explanation

Lower personal taxes raise disposable income, leading to higher consumer spending and increased aggregate demand.

iii Solution

Impact on Net Exports Component: Currency depreciation makes a country's goods cheaper for foreign buyers, increasing exports and decreasing imports

Shift of AD Curve: An increase in net exports will cause the aggregate demand curve to shift to the right

iii Answer

The aggregate demand curve will shift to the right due to an increase in net exports caused by currency depreciation.

Key Concept

Net Exports Component of AD

Explanation

A depreciating currency increases net exports by making domestic goods more competitive abroad, thus increasing aggregate demand.

iv Solution

Impact on Investment Component: Lower interest rates reduce the cost of borrowing, encouraging firms and consumers to increase investment and consumption

Shift of AD Curve: An increase in investment and consumption will cause the aggregate demand curve to shift to the right

iv Answer

The aggregate demand curve will shift to the right due to increased investment and consumption following a cut in interest rates.

Key Concept

Interest Rates and AD

Explanation

Lower interest rates reduce borrowing costs, stimulating investment and consumption, which in turn increases aggregate demand.

5. Using the aggregate demand and short run aggregate supply (AD-SRAS) model, illustrate and explain the effects on the equilibrium price level and real Gross Domestic Product (GDP) for each of the following events: (i) Due to the Covid-19 pandemic, many industries are at the verge of bankruptcy and start to lay-out workers especially in the hotel and tourism industries. (5 marks) (ii) During inflation, the general prices of all necessities have hiked, shrinking the ability of the public to consume. As a solution, the government implements the contractionary fiscal policy. (5 marks) 6. Using the aggregate demand and short run aggregate supply (AD-SRAS) model, illustrate and explain the effects on the equilibrium price level and real Gross Domestic Product (GDP) for each of the following events: (i) During the second Conditional Movement Control Order (CMCO 2.0), the government of Malaysia has announced the distribution of Bantuan Prihatin Nasional 2.0 to boost the purchasing power of the nation. (5 marks) (ii) During an economy downturn, many firms suffer from decrease in sales and higher inventories costs.

5 Solution

AD-SRAS Model Overview: The AD-SRAS model shows the relationship between aggregate demand (AD) and short-run aggregate supply (SRAS) and how they determine the equilibrium price level and real GDP

Effect of Industry Bankruptcy and Layoffs: - Layoffs and bankruptcies in the hotel and tourism industries reduce household income and increase unemployment. - This leads to a decrease in consumer spending, which is a component of AD. - The AD curve shifts to the left

New Equilibrium: - The leftward shift of the AD curve results in a lower equilibrium price level and a decrease in real GDP. - This reflects a recessionary gap where actual GDP is less than potential GDP

5 Answer

The equilibrium price level decreases, and real GDP contracts due to a leftward shift in the AD curve caused by industry bankruptcies and layoffs.

Key Concept

AD-SRAS Equilibrium Shift

Explanation

A decrease in consumer spending due to layoffs and bankruptcies shifts the AD curve leftward, leading to a lower equilibrium price level and reduced real GDP.

6 Solution

AD-SRAS Model Overview: The AD-SRAS model illustrates the interaction between aggregate demand and short-run aggregate supply in determining the overall economic equilibrium

Effect of Bantuan Prihatin Nasional 2.0: - The distribution of Bantuan Prihatin Nasional 2.0 increases household income. - This leads to an increase in consumer spending, which is a component of AD. - The AD curve shifts to the right

New Equilibrium: - The rightward shift of the AD curve results in a higher equilibrium price level and an increase in real GDP. - This reflects an expansionary gap where actual GDP is more than potential GDP

6 Answer

The equilibrium price level increases, and real GDP expands due to a rightward shift in the AD curve caused by the distribution of Bantuan Prihatin Nasional 2.0.

Key Concept

AD-SRAS Equilibrium Shift

Explanation

An increase in consumer spending due to government aid shifts the AD curve rightward, leading to a higher equilibrium price level and increased real GDP.