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Using Ad/as Diagrams, Analyse the Likely Impact on an Economy of a General Rise in Wage Costs and an Increase in the Money Supply by the Federal Reserve Bank.

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Summer Sizzler #2

Using AD/AS diagrams, analyse the likely impact on an economy of a general rise in wage costs and an increase in the money supply by the Federal Reserve Bank.

Aggregate supply (AS) measures the volume of goods and services produced within the economy at a given price level. A fall in worker productivity or firms paying higher wages to their employees can bring about a rise in wage costs. If wage costs rise, the result will be higher prices. This is explained in the diagram below:

Increase in Wage costs Graph

This is an example of cost-push inflation. Cost-push inflation is a type of inflation that occurs due to an overall rise in costs for factors of production. Cost-push inflation causes an inward shift of the SRAS. Hence a fall in SRAS causes the real output to decrease, and the general level of prices to rise in ceteris paribus. As seen in the diagram short run Aggregate Supply decreases from SRAS1 to SRA2 causing the price to increase from P1 to P2, and the real income to increase from Y1 to Y2.

If the Federal Reserve back decides to increase the money supply, like for example by using expansionary monetary policy. An increase in the money supply results in a decrease of interest rates. The extra money increases the purchasing power of business, households and also the government because everyone is able and willing to buy more at the same price level, hence all the factors of AD (consumption, investment, government purchases and even net exports) increase resulting in an increase in aggregate demand. This increase in AD is shown in the graph below:

Aggregate Demand

As seen from the graph, the decrease in interest rates raises the quantity of goods and services that are demanded at a given price level from Y1 to Y2, hence shifting Aggregate Demand from AD1 to AD2.

Scarcity is the basic economic problem of having unlimited needs with limited resources. A market economy is a type of economy that relies on market forces to allocate goods and resources and determine prices. There is no government intervention. Supply and demand both determine the prices of the different goods and services of the economy. This can be seen by a simple change of demand graph:

Market for Ice Lollies

The hot weather affects consumer's demand by changing consumer's taste for ice lollies. The weather changes the amount that consumers are willing to buy at a given price. Supply does not change as weather does not directly affect the firms. Because the hot weather increases consumer's willingness to buy, the demand curve shifts right from Demad1 to Demand2. This shift indicates that the quantity of ice



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