18

Aggregate Demand and Aggregate Supply

INTRODUCTION

This chapter introduces the model of aggregate demand and aggregate supply which can be used to study the joint determination of the output level and the price level. The aggregate demand curve has been derived from the IS–LM model. We attempt at examining why it slopes downwards and the reasons for the shifts in it. The aggregate supply curve has also been analysed in terms of the classical approach and the Keynesian approach. The intersection of the aggregate demand and aggregate supply curves determines the equilibrium level of output and the price level. The effects of a monetary expansion and supply shocks have also examined. (For further discussion on Aggregate Demand and Aggregate Supply refer to Appendix C)

THE AGGREGATE DEMAND CURVE

In the earlier chapters, we have examined the IS–LM model to explain the determination of the national income in the short run in two and three sector economies assuming a fixed price level. We now aim to study what will happen if the price level is allowed to vary in the IS–LM model. The aggregate demand curve shows the different combinations of output level and the price level at which the goods and money markets are simultaneously in equilibrium. We also attempt to derive the aggregate demand curve from the IS–LM model.

 

Figure 18.1 Derivation of the Aggregate Demand Curve from the IS–LM Model

The aggregate demand curve charts out the IS–LM equilibrium holding the nominal money supply and autonomous expenditures at a constant level but at the same time allowing the prices to change.

In Figure 18.1 (a) given the nominal money supply, M and given the price level at P₁, the IS and LM₁ curves intersect at point E₁ to determine the equilibrium income or output, or the equilibrium level of aggregate demand, at Y₁ and the rate of interest at r₁. At point E₁ there is simultaneous equilibrium in both the goods and the money markets. We, thus, get one combination of aggregate demand and the price level, Y₁ and P₁ as depicted in Figure 18.1 (b).

Suppose there is an increase in the price level to P₂ while there is no change in the nominal money supply. This increase in the prices will not have any impact on the goods market where all the variables are fixed in real terms and thus remain unaffected by any price changes. Hence, the IS curve will remain unaffected.

As far as the money market is concerned, given the nominal money supply, an increase in the prices will lead to a decrease in the real money supply. The LM curve will shift leftwards to LM₂. The curves IS and LM₂ intersect at point intersect at point E₂ to determine the equilibrium level of aggregate demand, at Y₂ and the rate of interest at r₂. We thus find another combination of aggregate demand and the price level, Y₂ and P₂ as in Figure 18.1 (b).

By repeating this exercise for different price levels, we can get different combinations of aggregate demand and the price level at which there is a simultaneous equilibrium in both the goods and money markets. By joining the points so obtained, we can derive the aggregate demand curve as in Figure 18.1(b). The aggregate demand curve is downward sloping because of the negative relationship between the aggregate demand and the price level.

Shifts in Aggregate Demand Curve

The aggregate demand curve is derived from the IS–LM curve. Hence, shifts in the IS or the LM curve will lead to shifts in the aggregate demand curve. The shifts in the IS and LM curves occur due to changes in the monetary or fiscal policy. To analyse the changes in the aggregate demand, we study the changes in monetary policy and fiscal policy.

 

1. Monetary policy: The effect of a monetary expansion is depicted in Figure 18.2(a). The intersection of IS and LM₁ curves determines the initial equilibrium at point E₁, with the rate of interest at r₁ and the income level at Y₁. The aggregate demand curve which corresponds to IS and LM₁ is given by AD₁.

 

An increase in the money supply for any given price level leads to an increase in the real supply of money thus shifting the LM curve downwards, from LM₁ to LM₂. The curve LM₂ intersects with the IS curve at point E₂. Hence the new equilibrium is at point E₂, with the rate of interest at r₂ and the income level at Y₂. The aggregate demand curve which corresponds to IS and LM₂ is given by AD₂. An increase in the money supply increases the equilibrium income and reduces the rate of interest in the IS–LM model and thus shifts the aggregate demand curve to the right. Conversely, any decrease in the money supply reduces the equilibrium income and increases the rate of interest and thus shifts the aggregate demand curve to the left.

The changes in the monetary policy influence the economy through what is called the monetary policy multiplier. The monetary policy multiplier depicts the changes in the equilibrium level of income due to an increase in the real supply of money while keeping fiscal policy unchanged.

2. Fiscal policy: The effect of a fiscal expansion is depicted in Figure 18.2(b). The intersection of IS₁ and LM curves determines the initial equilibrium at point E₁, with the rate of interest at r₁ and the income level at Y₁. The aggregate demand curve which corresponds to IS₁ and LM is given by AD₁.

 

An increase in the government expenditure or a decrease in taxes shifts the IS curve rightwards from IS₁ to IS₂. The curve IS₂ intersects with the LM curve at point E₂. The new equilibrium is at point E₂, with the rate of interest at r₂ and the income level at Y₂. The aggregate demand curve which corresponds to LM and IS₂ is given by AD₂. An increase in the government expenditure or a decrease in taxes raises the equilibrium income and increases the rate of interest in the IS–LM model and thus shifts the aggregate demand curve to the right. Conversely, any decrease in the government expenditure or an increase in taxes reduces the equilibrium income and decreases the rate of interest and thus shifts the aggregate demand curve to the left.

Figure 18.2 Shifts in the Aggregate Demand Curve

The changes in the fiscal policy influence the economy through what is called the fiscal policy multiplier. The fiscal policy multiplier depicts the changes in the equilibrium income level due to an increase in the government expenditure, holding the real supply of money constant.

• The aggregate demand curve is downward sloping due to the negative relationship between the aggregate demand and the price level.
• An increase in the money supply shifts the aggregate demand curve to the right.
• An increase in the government expenditure or a decrease in taxes also shifts the aggregate demand curve to the right.

THE AGGREGATE SUPPLY CURVE

We had derived the aggregate demand curve in the last section. In this section, we move a step further and derive the aggregate supply curve. The aggregate supply curve shows the quantity of the output that the firms are ready to supply for each given price level. A controversy surrounds the aggregate supply curve as far as its shape is concerned and we will attempt at arriving at an aggregate supply curve from the two differing views.

 

The Classical Approach to the Aggregate Supply Curve

Figure 18.3 depicts the classical approach to the aggregate supply curve. In the figure, the aggregate supply curve is vertical signifying that the same quantity of the output will be supplied whatever is the price level.

The basic assumption in the classical approach is that there always exists full employment in the labour market. The full employment is maintained through wage price flexibility. Hence the labour market, according to the classical theory, will always be in equilibrium. In such a situation, an increase in the price will not lead to an increase in the output as no more labour is available to produce any additional output. The firms will continue to supply the output Y* whatever is the price level.

The Keynesian Approach to the Aggregate Supply Curve

Figure 18.4 depicts the Keynesian approach to the aggregate supply curve. The figure shows an aggregate supply curve which is horizontal signifying that the firms will supply whatever amount of output is demanded at the existing price level.

The basic idea in the Keynesian approach is that there exists unemployment in the labour market. Thus at the current wage rate, firms can employ as much labour as they wish to employ. The underlying assumption in this approach is that the wages do not change due to the existence of unemployment. Hence, there is no change in the average costs of production in response to a change in the output level. At the existing price level, the firms are willing to supply whatever output is demanded. Hence according to the Keynesian approach, the aggregate supply curve is horizontal.

Figure 18.3 The Classical Approach to the Aggregate Supply Curve

Figure 18.4 The Keynesian Approach to the Aggregate Supply Curve

The Upward Sloping Aggregate Supply Curve

As is obvious from the above two approaches, the theory of aggregate supply is one of most controversial areas in macroeconomics. In a world which is ideal there is perfect wage price flexibility in the labour market and the economy would always be at full employment. This is the classical world. Reality is far different from this ideal world where the labour market adjusts at a very slow speed to changes in the aggregate demand.

A variety of models of aggregate supply have been put forward. All are of the same opinion that the short-run aggregate supply curve has a positive slope whereas the long-run aggregate supply curve is vertical. We derive the short-run aggregate supply curve with the help of following two approaches:

1. Derivation of the upward sloping aggregate supply curve through the change in real wage: The approach assumes that the money wage rate is fixed and that the marginal productivity of labour is diminishing. Figure 18.5 depicts the derivation of the aggregate supply curve by this approach.

   Quadrant A shows the aggregate production function for the economy as a whole with the axes having been reversed. It gives the aggregate output corresponding to a particular labour input.

   Quadrant B depicts the demand curve for labour, D_N (which is actually the marginal physical product of labour curve as labour will be hired till the marginal physical product of labour is equal to the real wage). Quadrant B also shows the supply curve of labour as positively related to the real wage.

   Quadrant C gives the various combinations of the price level and real wage. With the help of the curve W, one is able to identify the price level which will yield the indicated W/P on the basis of the money wage rate, W.

   Quadrant D shows how the aggregate supply function has been derived from the other quadrants in the figure.

   Starting with Quadrant A, when employment of labour is N₁ the output produced is Y₁. Quadrant B shows that N₁ units of labour will be demanded at a wage rate (W/P)₁. Quadrant C shows that producers must get a price level P₁ for an output of Y₁ to yield a wage rate of (W/P)₁, which is the wage at which the firms will hire labour of N₁ units to produce an output of Y₁ at a price level P₁. In Quadrant D, the Y₁ of Quadrant A and P₁ of Quadrant C combine to give the point H which is a point on the aggregate supply curve. Similarly, the other combinations of the output, Y and price level, P can be arrived at to get the aggregate supply curve in Quadrant D. Till the output level Y_f, the full employment output, the aggregate supply curve is upward sloping. At Y_f, the aggregate supply curve is vertical or perfectly inelastic because the output is now achieved to the maximum with the full employment of the labour force.

2. Derivation of upward sloping aggregate supply curve through the production function: In this approach, the aggregate supply curve is derived in following three steps:

   Step 1: Production function: The production function relates the output level to employment through the equation,

   

   Figure 18.5 Derivation of Upward Sloping Aggregate Supply Curve through the Change in Real Wage

    

   where	Y = output level
   	N = employment level

   l = input coefficient or labour productivity (which is the output produced per unit of labour employed)

   Step 2: Prices and cost: The main component of cost is the labour cost. A firm will supply an output such that the price it charges at least covers the cost. If W is the wages in the current period, then the cost per unit of labour is W/l. While determining the price the firms set a mark up, z over the price. The mark up z includes not only the costs of the other factors of production like raw materials but also includes the normal profits of the firm. Thus,

    

   P = W/l + z W/l = (1+z) W/l

   The above equation shows that the price level is proportional to the wage rate.

   Step 3: Phillips’ curve: The wages in the current period are linked to the wages in the previous period and to the employment level through the Phillips’ curve. (The Phillips’ curve has been analysed in Chapter 21).

   Also from the production function, the level of output is proportional to the employment level. Using this analysis we can arrive at a relationship between price and output which yields the upward sloping supply curve as in Figure 18.6.

   (For a more detailed explanation, see the Appendix to Chapter 18.)

• The main assumption in the classical approach is that there always exists full employment in the labour market.
• The basic idea in the Keynesian approach is that there exists unemployment in the labour market.
• In most models of aggregate supply, the short-run aggregate supply curve has a positive slope while the long-run aggregate supply curve is vertical.

Figure 18.6 Derivation of Upward Sloping Aggregate Supply Curve through the Production Function

Figure 18.7 Determination of the Output Level and the Price Level

THE AGGREGATE DEMAND AND AGGREGATE SUPPLY MODEL

We now bring together the aggregate demand and aggregate supply curves, which we have derived earlier in Figure 18.7. The aggregate demand curve, AD and aggregate supply curve, AS intersect at point E to determine the equilibrium output level at Y* and the equilibrium price level at P*. By construction, at the equilibrium point E,

1. The labour market is in equilibrium because point E lies on the aggregate supply curve.
2. The goods and financial markets are in equilibrium because point E lies on the aggregate demand curve.

• At the equilibrium point, the labour market is in equilibrium; the goods and financial markets are also in equilibrium.

THE EFFECTS OF A MONETARY EXPANSION

In Figure 18.8(a), the full employment level of output is Y*. The aggregate supply curve is drawn with prices, at say, P. The aggregate demand and supply curves intersect at point E where the economy is in full employment equilibrium. The aggregate supply curve is relatively flat as it is assumed that changes in output and employment do not have much effect on wages.

Next, suppose that there is an increase in the money supply. In Figure 18.8(a), there will be an outward shift of the aggregate demand curve from AD to AD₁. Therefore at the initial equilibrium price level P, there occurs an excess demand for goods. Hence, there will be a run-down on inventories. The firms will increase production until the short-run equilibrium is established at point E₁ where the output level is Y₁ while the price level is at P₁.

It is important to observe that at the short-run equilibrium E₁ the output level is above the normal output. Hence, there will be an increase in the prices. In Figure 18.8(b), the aggregate supply curve will shift upwards to AS, to AS₁, and finally to AS₃. Final equilibrium will occur at point E₃ where the AS₃ curve intersects the AD₁ curve, which is the full employment level.

At the final equilibrium E₃ (in the long run), prices have increased in the same proportion as the increase in the nominal money supply. Thus, the real money supply, M/P is at its initial level. Hence the aggregate demand, output and employment will also achieve their initial levels.

Figure 18.8 Effects of a Monetary Expansion

• A monetary expansion leads to an increase in price in the same proportion as the increase in the nominal money supply.
• The aggregate demand, output and employment achieve their initial levels.

EFFECTS OF A DECREASE IN GOVERNMENT BUDGET DEFICIT

In the last section we examined a monetary expansion, which led to a shift in the aggregate demand due to a change in the money market (and thus a shift in the LM curve). We now analyse a shift in the aggregate demand due to a change in the goods market (and thus a shift in the IS curve).

In Figure 18.9, the full employment level of output is Y*. The aggregate demand and supply curves intersect at point E where the economy is in full employment equilibrium.

Next suppose that the government is running a deficit in its budget and, hence, there is a reduction in the government expenditures. In Figure 18.9, there will be an inward shift of the aggregate demand curve from AD to AD₁. Therefore at the initial equilibrium price level P, the demand for the output is lower. The firms will reduce production until the short-run equilibrium is established at point E₁ where the output decreases from Y* to Y₁ while the price level also falls from P to P₁. Thus, the initial effect of a budget deficit is a reduction in the output.

Over a period of time as long as the output is below the full employment level, the aggregate supply curve will keep shifting downwards. The economy will move along the aggregate demand curve AD₁. Final equilibrium will occur at point E₃ where the AS₃ curve intersects the AD₁ curve, which is the full employment level. At the final equilibrium E₃(in the long run), the recession is over and the output level is the full employment level Y*.

There is a crucial difference between the effects of a change in the supply of money and the effects of a change in the budget deficit. At the point E₃ while the output is back to the full employment level, the price level and the interest rates are lower as compared to what they were before the shifts.

• A decrease in the government expenditures leads to an output level which is the full employment level.
• A decrease in the government expenditures leads to a price level and interest rates which are lower as compared to what they were before the shifts

EFFECTS OF A SHIFT IN AGGREGATE SUPPLY: SUPPLY SHOCKS

A supply shock is a sudden disturbance in the economy whose initial impact is a shift of the aggregate supply curve.

In Figure 18.10, an economy is in a long-run equilibrium situation at point E₁. Suppose unfavourable weather conditions lead to a destruction of crops. Alternatively, there is an increase in the real prices of oil. Whatever the reason, the impact is an increase in the costs of production. This leads to an upward shift of the short-run aggregate supply curve from AS₁ to AS₂ as shown in Figure 18.10. The economy is now in unemployment equilibrium at E. The economy’s output falls from Y₁ to Y while the price level rises from P₁ to P. Hence the economy is experiencing a falling output (stagnation) and increasing prices (inflation), a situation known as stagflation.

Figure 18.9 Effects of a Decrease in Government Budget Deficit

Figure 18.10 Effects of a Shift in Aggregate Supply: Supply Shocks

 

What should policy makers do in such a situation? There are two alternatives before the policy makers in such a situation:

 

1. They can just let things take their normal course. Over time, the recession will cure itself. Wages and prices will adjust themselves slowly and the aggregate supply curve will shift back to AS₁. In the long run, the economy will move back along the aggregate demand curve to point E₁.
   

   Figure 18.11 Adverse Supply Shock and Accommodating Monetary or Fiscal Policies

2. Policymakers may attempt to offset the effects of the shifts in the aggregate supply curve by using accommodating monetary or fiscal policies to shift the aggregate demand curve from AD₁ to AD₂ as shown in Figure 18.11. The economy reaches equilibrium at E₂ with the output at the full employment level Y₁ and prices at a higher level, P₂.

The problem for the policy makers is that though such a step would lessen the unemployment effects of the adverse supply shock, there would occur a price increase which would be equal to the full extent of the upward shift in the aggregate supply curve.

While an adverse supply shock leads to an increase the price level and a decrease in the GNP, the effect of a favourable supply shock would be just the opposite in that it would lead to a decrease in the price level and an increase in the GNP.

• Policymakers may attempt to offset the effects of the shifts in the aggregate supply curve by using accommodating monetary or fiscal policies to shift the aggregate demand curve.
• A favourable supply shock would lead to a decrease in the price level and an increase in the GNP.

THE SUPPLY SIDE ECONOMICS

We have already observed that the Keynesian short-run aggregate supply curve is horizontal indicating that the firms supply whatever goods are demanded at the existing level of prices. On the other hand, the classical short-run aggregate supply curve is vertical indicating complete wage price flexibility and an economy which would be always operating at the full employment level.

Supply side economics has proposed that decreasing the tax rates produces large increases in the aggregate supply. If one examines the truth one finds that tax cuts certainly lead to increases in the aggregate supply. However, the increases in the supply are much smaller than the increases in the aggregate demand.

Figure 18.12 Effects of a Tax Cut

Figure 18.12 examines the effects of a tax cut on both the aggregate demand and the aggregate supply curves. As individuals have more money in their hands, the aggregate demand curve shifts outwards from AD₁ to AD₂. As the lower tax rates encourages individuals to work harder, though only to a small extent, the aggregate supply curve shifts outwards from AS₁ to AS₂. Hence while there occurs a large shift in the aggregate demand curve, there occurs only a small shift in the aggregate supply curve.

In the short run, the economy’s equilibrium will move from E₁ to E with a considerable increase in the output level. However, this effect is completely due to a shift in aggregate demand curve alone. In the long run, the economy’s equilibrium will move to point E₂. Here while there is a very small increase in the output level, there occurs a permanent increase in the price level. Therefore, the total tax collections decrease while there is an increase in the government’s deficit. Some economists are in favour of reducing the government expenditures simultaneously with the tax cuts. Then the effect on the government deficit would be neutral.

• Tax cuts certainly lead to increases in the aggregate supply.
• Due to tax cuts while there occurs a large shift in the aggregate demand curve, there occurs only a small shift in the aggregate supply curve.
• Some economists are in favour of reducing the government expenditures simultaneously with the tax cuts.

INTRODUCTION

1. The chapter introduced the model of aggregate demand and aggregate supply.
2. While the aggregate demand curve has been derived from the IS–LM model, the aggregate supply curve has been analysed in terms of the classical approach and the Keynesian approach.
3. The effects of a monetary expansion and supply shocks have also been examined.

THE AGGREGATE DEMAND CURVE

1. We studied what will happen if the price level is allowed to vary in the IS–LM model.
2. The aggregate demand curve shows the different combinations of output level and the price level at which the goods and money markets are simultaneously in equilibrium.
3. The aggregate demand curve charts out the IS–LM equilibrium holding the nominal money supply and autonomous expenditures at a constant level but at the same time allowing the prices to change.
4. Suppose there is an increase in the price level while there is no change in the nominal money supply, the IS curve will remain unaffected while the LM curve will shift leftwards.
5. The aggregate demand curve is downward sloping because of the negative relationship between the aggregate demand and the price level.

SHIFTS IN AGGREGATE DEMAND CURVE

1. Shifts in the IS curve or the LM curve will lead to shifts in the aggregate demand curve.
2. The shifts in the IS and LM curves occur due to changes in the monetary or fiscal policy.
3. An increase in the money supply increases the equilibrium income and reduces the rate of interest in the IS–LM model and, thus, shifts the aggregate demand curve to the right.
4. The monetary policy multiplier depicts the changes in the equilibrium level of income due to an increase in the real supply of money while keeping fiscal policy unchanged.
5. An increase in government expenditure or a decrease in taxes raises the equilibrium income and increases the rate of interest in the IS–LM model and, thus, shifts the aggregate demand curve to the right.
6. The fiscal policy multiplier depicts the changes in the equilibrium income level due to an increase in government expenditure, holding the real supply of money constant.

THE AGGREGATE SUPPLY CURVE

1. The aggregate supply curve shows for each given price level, the quantity of output that the firms are ready to supply.
2. In the classical approach, the aggregate supply curve is vertical. The basic assumption in the classical approach is that there always exists full employment in the labour market.
3. In the Keynesian approach, the aggregate supply curve is horizontal. The basic idea in the Keynesian approach is that there exists unemployment in the labour market.
4. A variety of models of aggregate supply have been put forward. All are of the same opinion that the short-run aggregate supply curve has a positive slope whereas the long-run aggregate supply curve is vertical.
5. We can derive the short-run aggregate supply curve with the help of two approaches: through the change in real wages and through the production function.

THE AGGREGATE DEMAND AND AGGREGATE SUPPLY MODEL

1. The intersection of the aggregate demand and aggregate supply curves determines the equilibrium price and output level.
2. The labour market is in equilibrium at the equilibrium point.
3. The goods and financial markets are also in equilibrium.

EFFECTS OF A MONETARY EXPANSION

1. A monetary expansion leads to an outward shift of the aggregate demand curve.
2. At the final equilibrium in the long run, prices increase in the same proportion as the increase in the nominal money supply.
3. The aggregate demand, output and employment also achieve their initial levels.

EFFECTS OF A DECREASE IN GOVERNMENT BUDGET DEFICIT

1. A decrease in the government expenditures leads to a leftward shift of the aggregate demand curve.
2. A decrease in the government expenditures leads to a price level and interest rates which are lower as compared to what they were before the shifts.

EFFECTS OF A SHIFT IN AGGREGATE SUPPLY: SUPPLY SHOCKS

1. A supply shock is a sudden disturbance in the economy whose initial impact is a shift of the aggregate supply curve.
2. Due to an adverse supply shock, an economy may experience a situation known as stagflation.
3. Policymakers may attempt to offset the effects of the shifts in the aggregate supply curve by using accommodating monetary or fiscal policies to shift the aggregate demand curve.
4. While an adverse supply shock leads to an increase in the price level and a decrease in the GNP, the effect of a favourable supply shock would be just the opposite in that it would lead to a decrease in the price level and an increase in the GNP.

THE SUPPLY SIDE ECONOMICS

1. Supply side economics has proposed that decreasing the tax rates produces large increases in the aggregate supply.
2. However, the increases in the supply are much smaller than the increases in the aggregate demand.
3. While there is a very small increase in the output level, there occurs a permanent increase in the price level.
4. Therefore, the total tax collections decrease while there is an increase in the government’s deficit.
5. Some economists are in favour of reducing the government expenditures simultaneously with the tax cuts. Then the effect on the government deficit would be neutral.

TRUE OR FALSE QUESTIONS

1. The aggregate demand curve is upward sloping because of the negative relationship between the aggregate demand and the price level.
2. The fiscal policy multiplier depicts the changes in the equilibrium level of income due to an increase in the real supply of money while keeping fiscal policy unchanged.
3. An increase in the money supply increases the equilibrium income and shifts the aggregate demand curve to the right.
4. An increase in government expenditure or a decrease in taxes raises the equilibrium income and shifts the aggregate demand curve to the right.
5. A supply shock is a sudden disturbance in the economy whose initial impact is a shift of the aggregate supply curve.

VERY SHORT-ANSWER QUESTIONS

1. What is the aggregate demand curve? Why is it downward sloping?
2. What is the monetary policy multiplier?
3. What is the fiscal policy multiplier?
4. What is a supply shock?
5. What is stagflation?

SHORT-ANSWER QUESTIONS

1. What is the impact of an increase in the price level (while there is no change in the nominal money supply) on IS and LM curves?
2. Discuss the classical approach to the aggregate supply curve.
3. Discuss the Keynesian approach to the aggregate supply curve.
4. ‘The intersection of the aggregate demand and aggregate supply curves determines the equilibrium price and output level’. Explain.
5. What are the effects of an adverse supply shock? Discuss.

LONG-ANSWER QUESTIONS

1. ‘The aggregate demand curve charts out the IS–LM equilibrium while holding the nominal money supply and autonomous expenditures constant but allowing the prices to change.’ Explain.
2. Examine the shifts in the IS and LM curves that occur due to changes in the
   1. Monetary policy
   2. Fiscal policy
3. Show the derivation of the upward sloping aggregate supply curve through the change in real wages.
4. How can an upward sloping aggregate supply curve be derived through the production function? Explain.
5. Discuss the effects of a monetary expansion on the aggregate demand and supply curves.

TRUE OR FALSE QUESTIONS

1. False. The aggregate demand curve is downward sloping because of the negative relationship between the aggregate demand and the price level.
2. False. The monetary policy multiplier depicts the changes in the equilibrium level of income due to an increase in the real supply of money while keeping fiscal policy unchanged.
3. True. An increase in the money supply increases the equilibrium income and reduces the rate of interest in the IS–LM model and thus shifts the aggregate demand curve to the right.
4. True. An increase in government expenditure or a decrease in taxes raises the equilibrium income and increases the rate of interest in the IS–LM model and, thus, shifts the aggregate demand curve to the right.
5. True. Due to an adverse supply shock, an economy may experience a falling output (stagnation) and increasing prices (inflation), a situation known as stagflation.