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Question
1."prices are automatic regulator that tends to keep production and consumption in line with each other"-explain.      2. explain in detail why the aggregate demand curve is down sloping. specify how your explanation differs from rational behind the down sloping demamd curve for a simple product.

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1."prices are automatic regulator that tends to keep production and consumption in line with each other"-explain

EFFECTIVE  PRICING  SYSTEM  CAN HELP  TO  MAINTAIN    Market equilibrium
Which  occurs where quantity supplied [production ]
equals quantity demanded[consumption ], the intersection of the supply and demand curves in the figure . At a price below equilibrium, there is a shortage of quantity supplied [production ] compared to quantity demanded[consumption]. This is posited to bid the price up. At a price above equilibrium, there is a surplus of quantity supplied compared to quantity demanded. This pushes the price down. The model of supply[production ] and demand [consumption]  predicts that for given supply and demand curves, price and quantity will stabilize at the price that makes quantity supplied equal to quantity demanded. Similarly, demand-and-supply theory predicts a new price-quantity combination from a shift in demand (as to the figure), or in supply.
For a given quantity of a consumer good, the point on the demand curve indicates the value, or marginal utility, to consumers for that unit. It measures what the consumer would be prepared to pay for that unit.The corresponding point on the supply curve measures marginal cost, the increase in total cost to the supplier for the corresponding unit of the good. The price in equilibrium is determined by supply and demand. In a perfectly competitive market, supply[production ] and demand[ consumption ] equate marginal cost and marginal utility at equilibrium.
On the supply side of the market, some factors of production are described as (relatively) variable in the short run, which affects the cost of changing output levels. Their usage rates can be changed easily, such as electrical power, raw-material inputs, and over-time and temp work. Other inputs are relatively fixed, such as plant and equipment and key personnel. In the long run, all inputs may be adjusted by management. These distinctions translate to differences in the elasticity (responsiveness) of the supply curve in the short and long runs and corresponding differences in the price-quantity change from a shift on the supply or demand side of the market.

The supply and demand model describes how prices vary as a result of a balance between product availability and demand. The graph depicts an increase (that is, right-shift) in demand from D1 to D2 along with the consequent increase in price and quantity required to reach a new equilibrium point on the supply curve (S).

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2. explain in detail why the aggregate demand curve is down sloping. specify how your explanation differs from rational behind the down sloping demamd curve for a simple product.

In macroeconomics, the focus is on the demand and supply of all goods and services produced by an economy. Accordingly, the demand for all individual goods and services is also combined and referred to as aggregate demand. The supply of all individual goods and services is also combined and referred to as aggregate supply. Like the demand and supply for individual goods and services, the aggregate demand and aggregate supply for an economy can be represented by a schedule, a curve, or by an algebraic equation
The aggregate demand curve represents the total quantity of all goods (and services) demanded by the economy at different price levels. An example of an aggregate demand curve is given in Figure 1 .

Figure 1   An aggregate demand curve

The vertical axis represents the price level of all final goods and services. The aggregate price level is measured by either the GDP deflator or the CPI. The horizontal axis represents the real quantity of all goods and services purchased as measured by the level of real GDP. Notice that the aggregate demand curve, AD, like the demand curves for individual goods, is downward sloping, implying that there is an inverse relationship between the price level and the quantity demanded of real GDP.
The reasons for the downward-sloping aggregate demand curve are different from the reasons given for the downward-sloping demand curves for individual goods and services. The demand curve for an individual good is drawn under the assumption that the prices of other goods remain constant and the assumption that buyers' incomes remain constant. As the price of good X rises, the demand for good X falls because the relative price of other goods is lower and because buyers' real incomes will be reduced if they purchase good X at the higher price. The aggregate demand curve, however, is defined in terms of the price level. A change in the price level implies that many prices are changing, including the wages paid to workers. As wages change, so do incomes. Consequently, it is not possible to assume that prices and incomes remain constant in the construction of the aggregate demand curve. Hence, one cannot explain the downward slope of the aggregate demand curve using the same reasoning given for the downward-sloping individual product demand curves.
Reasons for a downward-sloping aggregate demand curve. Three reasons cause the aggregate demand curve to be downward sloping. The first is the wealth effect. The aggregate demand curve is drawn under the assumption that the government holds the supply of money constant. One can think of the supply of money as representing the economy's wealth at any moment in time. As the price level rises, the wealth of the economy, as measured by the supply of money, declines in value because the purchasing power of money falls. As buyers become poorer, they reduce their purchases of all goods and services. On the other hand, as the price level falls, the purchasing power of money rises. Buyers become wealthier and are able to purchase more goods and services than before. The wealth effect, therefore, provides one reason for the inverse relationship between the price level and real GDP that is reflected in the downward-sloping demand curve.
A second reason is the interest rate effect. As the price level rises, households and firms require more money to handle their transactions. However, the supply of money is fixed. The increased demand for a fixed supply of money causes the price of money, the interest rate, to rise. As the interest rate rises, spending that is sensitive to rate of interest will decline. Hence, the interest rate effect provides another reason for the inverse relationship between the price level and the demand for real GDP.
The third and final reason is the net exports effect. As the domestic price level rises, foreign-made goods become relatively cheaper so that the demand for imports increases. However, the rise in the domestic price level also means that domestic-made goods are relatively more expensive to foreign buyers so that the demand for exports decreases. When exports decrease and imports increase, net exports (exports - imports) decrease. Because net exports are a component of real GDP, the demand for real GDP declines as net exports decline.
Changes in aggregate demand. Changes in aggregate demand are represented by shifts of the aggregate demand curve. An illustration of the two ways in which the aggregate demand curve can shift is provided in Figure
2 .

Figure 2   Shifts of the aggregate demand curve

A shift to the right of the aggregate demand curve. from AD1 to AD2, means that at the same price levels the quantity demanded of real GDP has increased. A shift to the left of the aggregate demand curve, from AD1 to AD3, means that at the same price levels the quantity demanded of real GDP has decreased.
Changes in aggregate demand are not caused by changes in the price level. Instead, they are caused by changes in the demand for any of the components of real GDP, changes in the demand for consumption goods and services, changes in investment spending, changes in the government's demand for goods and services, or changes in the demand for net exports.
Consider several examples. Suppose consumers were to decrease their spending on all goods and services, perhaps as a result of a recession. Then, the aggregate demand curve would shift to the left. Suppose interest rates were to fall so that investors increased their investment spending; the aggregate demand curve would shift to the right. If government were to cut spending to reduce a budget deficit, the aggregate demand curve would shift to the left. If the incomes of foreigners were to rise, enabling them to demand more domestic-made goods, net exports would increase, and aggregate demand would shift to the right. These are just a few of the many possible ways the aggregate demand curve may shift. None of these explanations, however, has anything to do with changes in the price level.

Three explanations for the negative slope are:
1. Interest rate effect
2. Real balance effect
3. Foreign purchases effect

Aggregate demand (AD) is a curve showing the total amount of goods and services (real GDP) that will be purchased at different price levels.

1. Interest rate effect:
As price level (P) rises, the real money supply (=nominal money supply/P) falls. This leads to an increase in interest rate. As interest rate rises, investment spending falls because of the increased cost of borrowing to finance investment. As investment falls, aggregate expenditure (AE) falls, in turn leading to a fall in real GDP (or Y). (Hence we see as P increases, Y decreases.)

Try picturing this in terms of the IS-LM model too. The fall in the real money supply, which leads to an increase in interest rate, causes the LM curve to shift leftwards. Along an unchanged downward sloping IS curve, this results in a fall in equilibrium real GDP because of an upward movement** along the IS curve (**we say upward movement because as interest rate rises, investment spending falls, AE falls and hence real GDP falls). This confirms our conclusion that a rise in P leads to a fall in real GDP.

NOTE: The interest rate effect is by far the dominant reason for a downward sloping AD curve.

2. Real balance effect (also known as real wealth effect or real money balances effect):
It operates through consumption. As price level rises, purchasing power of money balances falls. As our real wealth falls, we will cut back on our consumption spending; hence autonomous consumption (Co) falls. This results in a decrease in AE and hence a decrease in real GDP.

We can also picture this in terms of the IS-LM model. The fall in AE leading to a decrease in real GDP occurs at an assumed unchanged interest rate. This shifts the IS curve leftwards from IS(0) to IS(1). With an unchanged upward sloping LM curve, the fall in real GDP lowers transactions demand for money and hence total money demand (which comprises both transactions demand and asset demand components). This in turn lowers interest rate (that is, a downward movement along the LM curve). As interest rate falls, we know that investment spending will rise and hence AE and real GDP will rise (that is, a downward movement along IS(1)). [Of course, this rise in real GDP is not enough to offset the original fall in real GDP because to the downward sloping nature of the LM curve.] This ensures attainment towards simultaneous equilibrium in money market and output market. Overall, we trace that a rise in P leads to a fall in Co, AE, and hence Y.

3. Foreign purchases effect:
It is applicable only to open economies with foreign trade being introduced into our explanation. With an increase in domestic price level relative to those of trading partners, domestic consumers will spend less on domestically produced goods and services and more on imports (M). Also, foreigners will buy less of our exports (X). The increase in M and decrease in X (that is, a decrease in net exports) means a decrease in real GDP.

In terms of our IS-LM model, the decrease in net exports causes a fall in AE, a fall in real GDP and hence a leftward shift in the IS curve. With an unchanged LM curve, we notice an overall fall in both interest rate and real GDP (as we have explained in our "real balance effect"). It is conclusive that a rise in P leads to a fall in Y.
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