Module 12 and 13

Running head: MODULE 13 1

MODULE 13 5

Module 13

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Instructions

 In 2014, China’s economy slowed significantly causing a decrease in demand for US exports.

Use the AD/AS model to explain the likely short run impacts on US GDP and the aggregate price level. What do you anticipate will happen to US consumption expenditure and US employment? Please explain your reasoning for each of your predictions and show graphically as appropriate.

In the short-run, the wages as well as certain prices do not react to the changes in economic conditions (Mankiw, 2015). In other words, they are sticky. Hence, the economy may work below or above potential output. The unemployment will be above or below the natural level of unemployment.

The model below shows the moves of the AD and AS in the short-run. The aggregate supply curve (SRAS) slopes upward in the short-run. As price level increases, the supplies of goods and services increases. When the price level is 1.2, the supply is 12. When the price moves to 1.4, the supplies are 14.

			Aggregate Demand (AD) and Aggregate Supply (AS) in the short-run
Price level
	2						SRAS
					C
	1.8
				B
	1.6			A
	1.4							AD3
								AD2
	1.2
							AD1
	0	12	14	16	18	20	22
					Real GDP ($ trillions)

The aggregate demand (AD) of these commodities is high when the price level is low. When the price increases, demand declines. When the price is 1.2, the quantity demanded is 20. When the price rises to 1.4, the demand reduces to 13. A low price level triggers the consumer to believe in having more money and will spend it.

The equilibrium point is 1.7 and 17.8. Suppose the U.S. exports to China increase, the aggregate demand shifts from AD2 to AD3 because of the excess demand. As a result, the potential output increases from 17.8 to 19.5. The aggregate demand falls from AD2 to AD1 if the exports decline. This means that price level and real GDP falls when aggregate demand reduces to AD2. When aggregate demand increases to AD3, the price level and real GDP increases. According to Mankiw (2015), the aggregate demand curve is affected by consumer expenditure, interest rate effect (the interest rate is lowered by a low price level. This triggers consumer spending on investment), and exchange rate effect (the resultant reduction in interest rate causes real exchange rate depreciation. Depreciation raises exports).

The output can be increased beyond potential level. Suppose some people who were not employed find work because it is easy to get a job at the nominal wage. The potential output moves to point C but at a higher price. Assume that aggregate demand reduces (AD1), because of a decline in investment. As price level begins to fall, the output falls. The economy settles at a price to output combination at which the real GDP is below potential, at point A. The cause is price stickiness. The prices received by firms are declining with the decline in demand. The real wage will increase as there are no reductions in the nominal wages. Less labor will be employed by firms and less output will be produced.

A rise in natural resources prices such as oil or other factor of production increases the production cost and results in the SRAS shift to the left (SRAS1). A decline in natural resources prices would lower the production cost and would enable more production shifting the curve to the right (SRAS2). The other factors which affect SRAS are capital stock and technology level.

Price level					SRAS1
	2						SRAS
							SRAS2
	1.8
	1.6
	1.4
	1.2
	0	12	14	16	18	20	22
					Real GDP ($ trillions)

Reference

Mankiw, N. G. (2015). Principles of macroeconomics (seventh edition). Stamford, CT, USA: Cengage Learning.