Assuming no changes in Government spending, taxes and the money supply, explain, with the help of suitable diagrams, why aggregate demand depends negatively on the price level.
AD = C + I + G + (X – M)
While there are no changes in government spending, taxes and the money supply, (law of demand) aggregate demand depends negatively on the price level. The effect of law of demand is illustrated in the graph above. When price level rises, quantity falls; while P moves upwards to P1, Q shifts to the left, Q1. As price rises, consumers are not so willing to buy the products and might switch to the substitution products. Consumer receiving the fixed income will switch to inferior goods due to the increase of price level. When this happen, AD shift to the left. When price level drops, quantity rises; while P moves downwards to P2, Q shift to the right, Q2. As price drops, consumers are more willing to buy a larger amount of the product. More goods are demanded, the curve of AD will shift to the right.
Explain, with the help of aggregate supply and aggregate demand schedules, the effect of the following events on the price level and on the equilibrium national income:-
(i) A tax cut holding government purchases constant with the economy operating at near full capacity.
When there is a cut in tax, consumer expenditures rises as they are more willing to spend for the lesser amount they pay for the tax. According to the macroeconomic equation C + I + G + (X – M) = AD, the increase of consumption, investment and export contributes to the overall increase of aggregate demand. The curve of aggregate demand shift from AD to AD1 and the price to increase from P to P1. This has cause price inflation to occur with the economy of operating at near full capacity.
(ii) An increase in the money supply during a period of high unemployment and excess industrial capacity.
According to a normal business...