The government observes that prices are steadily increasing, and needs to figure
ID: 1119800 • Letter: T
Question
The government observes that prices are steadily increasing, and needs to figure out if this increase in prices is due to fall in aggregate supply against stable aggregate demand or an increase in aggregate demand against a stable aggregate supply. The cause of the increase can be due to any of these three sectors: consumption, money market or the production factors market (raw materials, labor). Consider each of the following three cases and identify which of the three sectors caused the price increase. Support your answer with IS, LM, and aggregate production function and macroeconomic model.
1. There is no unemployment. Wages and raw materials prices are slowly increasing. Interest rates are are increasing.
2. There is no unemployment. Wages and raw materials prices are slowly increasing. Interest rates are decreasing.
3. Unemployment is expanding. Real wages and real value of raw materials prices are decreasing. Inventories of capital goods are increasing.
Explanation / Answer
Case 1: If there is no unemployment, this means that the economy is operating at full employment. Now since wages and raw material prices are increasing, firms will decide to produce less due to higher cost of production. As a result, Aggregate Supply(AS) curve will shift leftwards.
Since we are observing an increase in interest rates, this would have caused by an increase in consumption which causes IS curve to shift upwards and interest rates to rise. As a result, Aggregate Demand curve will also shift to right.
As a result of rightward shift in AD and leftward shift in AS, price level will rise.
Case 2 : Again the economy is at full employment. As in Case 1, rising wages and prices would lead to leftward shift in AS curve.
Since we are observing a fall in interest rates, this could have been caused by an increase in Money supply which would cause the LM curve to shift rightwards. This will aslo cause a rightward shift in AD curve. Again, rightward shift in AD and leftward shift in AS will lead to increase in price level.
Case 3: Lower real interest rates will reduce the costs of major products such as cars and will boost both consumption and investment. The aggregate demand curve will shift to the right. This causes price level to rise.
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