Tutorial 2

1. What causes the aggregate demand curve shift to the right? Explain by using the AD- AS
curve.
Answer: The aggregate demand curve, or AD curve, shifts to the right as the components of
aggregate demand—consumption spending, investment spending, government spending, and
spending on exports minus imports—rise.
P
AD2 AS
AD1

The graph on the top shows an outward shift of the aggregate demand curve. If consumers,
businesses, or foreigners decide to increase their spending, the AD curve will shift outward.
Government policy variables can also shift the AD curve. If the government decides to increase
its spending, the AD curve will shift outward. A tax cut provides consumers with more
disposable income, and they may decide to increase their spending. Increasing the money supply
will lower the interest rate and businesses will find investments more profitable and may decide
to increase their spending.

2. What causes the aggregate supply curve shift to the left? Explain by using the AD- AS
curve.
Answer: The aggregate supply curve shifts to the left as the price of key inputs rise, making a
combination of lower output, higher unemployment, and higher inflation possible.

AS1
AD AS0

Price Level
P1

P0

Real GDP
 3. Draw an aggregate demand and aggregate supply diagram for Japan. In the diagram,
show how each of the following affects aggregate demand and supply.

(a) The level of price in Korea falls.

AD1 AD2 AS

Price Level
P 0

P1

Real GDP
A fall in price level increases import demand and shifts the Aggregate Demand Curve to
Left.

(b) Labor receives a large increment in salary.

AS1
AD AS0

Price Level
P 1

P0

Real GDP

A rise in salary/ wage rate increases cost of production and reduces aggregate supply.

(C) Economists predict higher prices next year.

A higher price in the future increases current AD, because price level is relatively low currently.

AD2 AS
AD1

P1
P

S
 4. Use an aggregate demand and aggregate supply diagram to illustrate and explain how
each of the following will affect the equilibrium price level and real GDP:

(a) Consumers expect a recession

AD0 AS
AD1

Price Level
P 0

P1

Real GDP

If the consumer expects a recession, then they will not spend as much money today as to "save
for a rainy day". Thus, if spending has decreased, then our aggregate demand must decrease. An
aggregate demand decrease is shown as a shift to the left of the aggregate demand curve, as
shown below. Note that this has caused both Real GDP to decrease as well as the price level.
Thus, expectations of future recessions act to lower economic growth and are deflationary in
nature.

(b) Foreign income rises.

AD1 AD2 AS

Price Level
P1
P

Real GDP

If foreign income rises, then we would expect that foreigners would spend more money - both in
their home country and in ours. Thus, we should see a rise in foreign spending and exports,
which raises the aggregate demand curve. This is shown in our diagram as a shift to the right.
This shift in the aggregate demand curve causes Real GDP to rise as well as the price level.
 (c) Foreign price levels fall.

AD0 AS
AD1

Price Level
P 0

P1

Real GDP

If foreign price levels fall, then foreign goods become cheaper. We should expect that consumers
in our country are now more likely to buy foreign goods and less likely to buy domestic made
products. Thus the aggregate demand curve must fall, which is shown as a shift to the left. Note
that a fall in foreign price levels also causes a fall in domestic price levels (as shown) as well as a
fall in Real GDP, according to this Keynesian framework.

(d) Government spending increase.

AD1 AD2 AS

Price Level
P1
P

Real GDP

This is where the Keynesian framework differs radically from others. Under this framework, this
increase in government spending is an increase in aggregate demand, as the government is now
demanding more goods and services. So, we should see Real GDP rise as well as the price level.
 (e) Workers expect higher future inflation and negotiate higher wages now.
AS1
AD AS0

Price Level
P1

P0

Real GDP

If the cost of hiring workers has gone up, then companies will not want to hire as many workers.
Thus, we should expect to see the aggregate supply shrink, which is shown as a shift to the left.
When the aggregate supply gets smaller, we see a reduction in Real GDP as well as an increase
in the price level. Note that the expectation of future inflation has caused the price level to
increase today. Thus, if consumers expect inflation tomorrow, they will end up seeing it today.

There are various determinants that affect aggregate supply and aggregate demand curve. The
component of the aggregate demand curve which shift the demand curve is investment,
consumption, taxes, government expenditure, imports, and exports. The determinants which
affect the aggregate supply curve are the cost of production, technology, and future
expectations.