Objective 1:
i) Aggregate demand shows demand for real GDP by all the people in an economy, which they are willing and able to buy at different possible prices at a given point of time, holding other factors constant. The aggregate demand curve is downward sloping and shows an inverse relationship between price level and real GDP.
Following is the explanation for downward sloping demand curve, which is very much different from income and substitution effects of demand of a single product:
1) Interest Rate Effects:
When price levels increases in the economy, businesses and industries, have to borrow additional funds to complete their planned purchase plans. However, as the borrowing amount in the economy increases, this will lead to increase in the interest rates which actually leads to fall in total planned borrowings and hence results in lower consumption and investment, vice versa. Thus, with increase in price levels demand for Real GDP falls.
2)Wealth and Real Balance Effect:
When price levels falls in the economy, this increase the purchasing power of the people and finally results in increased spending and consumption by people.
3)Effect of Foreign Purchases:
When price level falls, this indicates that domestic prices in US are relatively cheaper than in offshore markets. Hence, with fall in price levels, quantity demanded for US exports rises i.e exports and domestic demand rises, while the level of imports falls as the reduced imports are in favor of US products.
The above discussed factors cause only movement along the AD curve and does not explain the reasons for shift in AD curve as only a change in economic variable other than price of the output will explain the shift in AD curve. Following factors are the one that cause shift in aggregate demand and each factor buys itself a portion in GDP:
1) Consumption: Wealth, interest rate, income taxes, and expectations about future prices and incomes will change C and shift AD curve.
2. Investment: Interest rate, business taxes, and expectation about future sales will change I and shift AD curve.
3. Foreign Sector: Foreign real national income and exchange rate will change export and import, causing AD curve to shift.
4. Money Supply: The money supply affects interest rates. An increase in money supply will lower interest rate, causing the AD curve to shift to the right.
ii) Aggregate Supply refers to real GDP available at each possible prices at a given point of time, other things remaining constant. The aggregate supply curve is upward sloping which indicates that producers of the good are and will be willing to sell more of their produce as price level rises, vice versa.
Following are the factors explaining upward rising slope of Aggregate Supply:
1) Rigid Wages: Most of the economist believe that the wages are fixed by legal contracts and when price level rises and wage levels still sustain at contractual rates, the producers earn profits and the firm will produce more.
2) Sticky Prices:Change in price levels is a costly affair and thus, decrease in the general price levels will negatively affect sales, profit, output and resultant fall in production levels.
Just like Aggregate Demand, the above factors explain only the movement along with aggregate supply curve and are as follows:
1)The Wage Rate: Wage rate is an important determinant of supply curves because at times of constant prices, higher wage rates will result in high production costs and reduced profit per unit and resulting low production levels. Therefore, higher wage rates will shift the SRAS Curve to the left.
2)Prices of Non-labor inputs: Energy, land, capital and other non-labor inputs also have a significant impact on SRAS. An increase in the price of these inputs shifts the SRAS curve to the left.
3)Productivity: This refers to output capacity per unit of input. Thus, higher productivity achieved through training of labor or technological advancement will shift the shift the SRAS to the right.
4) Supply Shock: Any natural or institutional shock will also affect Aggregate Supply. For Instance, Iraq War saw a drastic fall in AS levels of the Iraq economy.
Important to note that the above factors are prevalent only during short-run and not during long-run. In the long run, economy will always produce the full employment real GDP, known as Potential GDP and long run aggregate supply curve(LRAS) will be vertical and only a change in potential GDP will shift the LRAS Curve.
Objective 2:
The classical Economist always considered the market to be self-regulating and through self-adjustments, market will move towards long run equilibrium. For instance, if the economy is in recession i.e where real GDP< nominal GDP, in such case Government need to involve into fiscal measures as people who are unemployed will settle for lower wages. Lower wages will further raise the short run AS Curve and will cause the prices to decrease. Lower prices will increase consumption and the process will continue till the economy achieve the level of natural real GDP.
However, it was J.M.Keynes, who during 1930’s refute the classical idea that market are self regulatory and forwarded the idea that wages and prices are not flexible and government has to employ measures to bring the economy back to sustainable level. For Instance, at times of recession government may employ fiscal measures and decrease the taxation rates/increase the government expenditure. This will stimulate the level of Aggregate Demand in the economy and market will not be left over with surplus inventory as with increased government expenditure and lower taxations, income of the individuals rises and thus, there was nothing like self-regulation in the economy as proposed by Classical Economist.(Colander, 2010)
References:
Colander, D. C. (2010). Macroeconomics (8th ed.). Boston, MA: McGraw-Hill/Irwin.
