Macroeconomics: Aggregate Demand & Supply

This solved assignment delves into the concepts of macroeconomic equilibrium, analyzing how changes in aggregate demand and supply impact GDP and price levels. It explores the effects of tax cuts on consumer purchasing power and aggregate demand. Furthermore, it examines the neoclassical growth model, illustrating the concept of steady state equilibrium and the influence of factors like population growth and savings rates on long-run economic growth.

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Question 1 (2 + 2 + 2 = 6 marks)
The expectations augmented Phillips Curve has the form: π=π❑
e −ε (u−u¿). Suppose that
currently in the economy we have, ∆ M
M =π =π❑
e
=20 %, u=u¿=5 % and some points along
the expectations augmented Phillips Curve are illustrated in the table below.
Exhibit A
Price Inflation (π
)
% Unemployment Rate (u)
24 3
22 4
20 5
18 6
16 7
14 8
(a) Given the data in the table calculate the value of ε in the expectations augmented
Phillips Curve.
π=π❑
e −ε (u−u¿)
In this, the above mentioned present elements show the following:
Π = inflation
Πe = expected inflation
β = It denotes response of inflation in relation to the cyclical unemployment
(u - un) = cyclical unemployment
V = supply shocks
From evaluation, it has been identified that the value of slope is -2 respectively. Hence, by
considering such aspect it can be stated that situation of situation of cyclical unemployment has
negative impact on the inflationary trend or aspect. Thus, it can be said that value of β is -2 which in
turn shoes that inflation level decreases in line with the situation of cyclical unemployment.
(b) The central bank would like to have, ∆ M
M =π =0 %. Illustrate the gradualist and cold-
turkey approaches to getting inflation down using the Phillips Curve assuming
adaptive expectations. In the case of the gradualist approach assume that ∆ M
M is cut
in two sets; first to 10% then to 0%. Identify the maximum unemployment rate that
will be reached in the case of the cold-turkey approach.

There are mainly two strategies that can be employed by central bank to reduce the level of inflation
namely gradualist and cold-turkey approach. Gradualist approach lays emphasis on making small
reduction in the money supply growth rate. This in turn places positive impact on the shift which
takes place in the level of aggregate demand and supply. Hence, such approach ensures full
employment at lower inflation rate. On the other side, cold turkey approach starts with the huge
reduction in the growth of money supply rate. It is one of the major aspects which in turn differentiate
both the approaches from each other to some extent. By considering the cold-turkey approach it can
be stated that maximum level of unemployment is 10% in accordance with the formula of
∆ M
M =π =0 % at different sets.
(c) For the case of cold turkey, how would the adjustment process you outlined above
differ if economic agents had rational expectations? [Instructions: No diagramsshould
be used here. Explain your answer in words. Maximum 100 words. You must enter
the word count of your answer.]
In economics, rationale expectations may be defined as a economic theory which presents that
individual agents take their decisions by undertaking the best information which is available to them.
Along with this, economic agents also consider past trends while taking decisions. Rationale
expectations imply that economic agents should take decisions by taking into account the learning
from past trends. Cold-turkey approach lays emphasis on holding the money supply growth rate low
to the significant level. Moreover, such approach assists in reducing the inflation rate and thereby
facilitates high level of output and employment. Thus, expectation level of economic agents and
adjustments according to the cold-turkey approach do not differs significantly.
Question 2 (2 + 2 = 4 marks)
Suppose that the economy is at full employment and is hit by a negative supply shock such as
a large rise in oil prices.
(a) Illustrate this in an AD-AS diagram indicating the new level of prices and output.

(b) Discuss and illustrate in an AD-AS diagram the short run and long run effects on the
economy of the central bank adopting the following policies. [Instructions: Maximum
50 words. You must enter the word count of your answer.]
(i) doing nothing
In the case of contractionary monetary policy, when money supply decreases in the market then it
may result into decline in the level of nominal output. Moreover, in this, individuals do not have
enough funds for spending so aggregate demand curve shifts to the right. Thus, in the case of no
changes spending level of customers will be neither too high nor too lower.
(ii) increasing the money supply
By doing assessment, it has been identified that when money supply increases and interest rate
decreases then it may result into higher output as well as GDP. Moreover, when money supply
increases in the market then firms lay emphasis on investing money in the market which in turn may
result into high employment. Along with this, in the case of more money supply spending level of
customers also increases to a great extent. Hence, due to such aspect aggregate demand curve shifts to
the left.
Question 3 (2 + 2 = 4 marks)
Suppose that Trumponomics—the economic policy of new President of the United States,
Donald Trump—seems likely to involve cutting taxes and increasing government spending.
(a) Illustrate what you think the effects of such a policy are likely to be on price and
potential output in the long run using an AD-AS model in. [No discussion needed.
Illustrate your diagram clearly.]

(b) Discuss how the nature of the changes you illustrate in (a) will depend upon exactly
what kind of tax cuts and spending increases are implemented. [Instructions:
Maximum 150 words. You must enter the word count of your answer.]

The above depicted diagram shows that equilibrium is when aggregate demand (AD) and supply
curve puts together. Hence, changes which take place in aggregate demand or supply have direct
impact on the GDP as well as price level. From assessment, it has been identified that quantity of
GDP demanded equals to the quantity supplied then it is considered as short-run macroeconomic
equilibrium. However, condition of short-run equilibrium does not take place when full employment
level exists. When real GDP equals to the potential one then long run macro equilibrium exists.
Further, it has been identified that reduced tax level places positive impact on the purchasing power of
individuals because it increases their disposable income to a great extent. Hence, AD curve shifts to
the right when level of government spending increases. Besides this, shift which takes place in the
aggregate demand in response to tax cut is highly dependent on the size of tax multiplier to the
significant level.
Question 4 (2 + 2 + 2 = 6 marks)
In the following questions we are considering the neoclassical growth model.
(a) In a diagram illustrate an economy in a steady state. Identify the steady state level of
output per capita ( y¿) and capital per capita ( k ¿). Also determine the growth rate in y,
k, output (Y ) and capital (K ) at the steady state as a function of the model
parameters;the savings rate ( s), the population growth rate ( n) and the depreciation
rate (d). [Instructions: Maximum 100 words.You must enter the word count of your
answer.]
Neoclassical theory entails that labour; capital and technology are the main elements that place high
level which in turn closely influences the steady economic growth rate. This theory states that by

varying the amount of labour and capital in the production function position of equilibrium can be
attained. However, such theory also claimed that without using highly advanced technology firm
cannot attain success. Further, it can be stated that when saving rates increases then equilibrium shift
to the right. This in turn may also result into incline in capital and income per head to k*** & Y***
respectively.
(b) Suppose there is an increase in the population rate to n' >n. Illustrate the new steady
state equilibrium for output per capita ( y¿), capital per capita (k ¿) relative to that in
(a). Also determine the growth rate in y, k, Y and K at the steady state as a function of
the model parameters compared with that in (a). [Instructions: Maximum 100 words.
You must enter the word count of your answer.]
It can be seen from the table that due to increase in the population growth rate upward movement
happened in the (n+d) K line. It can be observed that population change from the n to n’ this lead to
upward shifting in the (n+d)k to (n+d)L dotted curve. At point T’ (n’+d)K is intersecting the saving
rate and due to this reason capital per head reduced from K*1 to K*2 and output per capital declined
from y*1 to Y*2.
(c) Given your answer in (b) comment on the effectiveness of population growth as a
driver of increases in the steady state output per capita. Discuss other factors which
could lead to rises in steady state output per capita in the neoclassical growth model.
[Instructions: No diagram should be used here. Maximum 200 words. You must enter
the word count of your answer.]
When lower growth rate take place in the population the population then there will be less
requirement of saving and investment to widen the capital. Hence, it is one of the main reasons due to
which level of capital per worker and level of output per worker will be higher to a great extent.