Consider a macroeconomy was initially at equilibrium level of real GDP. Using an aggregate demand and aggregate supply diagram or model of the economy, graphically illustrate and discuss the short-run and long-run effects of the following events upon the economy:
According to Gamber and Colander (2006, p.110), aggregate demand includes household consumption, investment, government expenditure and net exports, whereas aggregate supply is the output generated in the economy at different price levels. As the aggregate demand curve shifts left, the GDP levels decrease owing to change in equilibrium and vice versa. All the given events seem to have an impact on the aggregate demand alone. Aggregate supply will be impacted by quantity, quality and prices of resources (Aggregate supply determinants, n.d.).
(a) The Central Bank within the economy lifts interest rates.
According to Tucker (2012, p.261), increase in interest rates will discourage households and businesses from obtaining loans, since the cost of borrowing would be higher. There will be lower profits out of investments to businesses and hence this will lead to a lower GDP level and a higher price. So the aggregate demand curve will be shifted to the left.
(b) There is an increase in private domestic investment spending.
In aggregate demand, the investment refers to private domestic investment. When the businesses are optimistic and confident about their success of profitable investments, they will invest more for expanding their assets such as plants and equipments and there will be an increase in the private domestic investment spending. Since investment is one of the components of aggregate demand, as private domestic investment spending increases, the aggregate demand increases as well (Tucker, 2012, p.262). So the diagram will be the reverse of the above situation.