Introduction to Macroeconomics

9. Aggregate Supply and Aggregate Demand - Sample Problems

Contents

1. Aggregate Supply/Demand

1. Aggregate Supply/Demand

1. How is the supply curve for an individual product different from the aggregate supply curve? Unlike the aggregate supply curve, the supply curve for an individual product:
   1. indicates the responses of firms to change in RELATIVE prices
   2. slopes the way it does because of SWITCHING among products
   3. almost certainly slopes upward to the right
   4. is drawn on the assumption that the public's income is constant
   5. all of the above

   Answer: E. The individual product supply curve measures the response of firms to a change in the price of that particular good. Firms respond because it represents a change in the price of that good relative to the prices of all other goods (answer A). As the price of that good increases relative to the price of all other goods, firms switch to producing that good (Answer B). This behavior implies the individual product supply curve slopes upward to the right (answer C), given the ceteris paribus assumptions that include unchanged income (answer D).

   The aggregate supply curve shares no common foundations with the individual product supply curve. The aggregate supply curve relates total output of the economy to the average level of prices. Since the output includes all products and the average level of prices includes all prices, relative prices and switching between products plays no role (answers A and B). It is quite possible for the aggregate supply curve to be flat rather than upward sloping as we will find in the following chapters (answer C). Income can also no longer be considered constant (answer D). A change in the aggregate output of the economy (a movement along an aggregate supply curve) implies a change in aggregate income.

2. Which do you suppose is better for the economy, an increase in aggregate demand or an increase in aggregate supply? What is the difference?

   Answer:If the economy is initially at full employment, an increase in aggregate demand will create inflation. Under such circumstances, increases in aggregate supply (demand assumed constant) will increase output and decrease the price level. If high unemployment is situation (e.g., recession) and the aggregate supply curve is positively sloped (upward sloping rather than flat), an increase in either aggregate demand or aggregate supply will move the economy closer to full employment.

File last modified: September 1, 2002

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