1.

Unemployment increase during business cycle recession and decrease during business
cycle recoveries.
on the other hand inflation decrease during business cycle recession and increase
during business cycle recoveries. Briefly describe the effect of the business
cycle on the inflation rate and the unemployment
rate. Why might the unemployment rate continue to rise during the early stages of a
recovery?

3. Explain the three reasons why the aggregate demand (AD) curve slopes downward.

The first reason for the downward slope of the aggregate demand curve is wealth
effect. The nominal value of money is fixed, but the real value is dependent upon
the price level. This is because for a given amount of money, a lower price level
provides more purchasing power per unit of currency. When the price level falls,
consumers are wealthier, a condition which induces more consumer spending. Thus, a
drop in the price level induces consumers to spend more, thereby increasing the
aggregate demand.

The second reason for the downward slope of the aggregate demand curve is interest-
rate effect. The quantity of money demanded is dependent upon the price level. That
is, a high price level means that it takes a relatively large amount of currency to
make purchases. Thus, consumers demand large quantities of currency when the price
level is high. When the price level is low, consumers demand a relatively small
amount of currency because it takes a relatively small amount of currency to make
purchases. Thus, consumers keep larger amounts of currency in the bank. As the
amount of currency in banks increases, the supply of loans increases. As the supply
of loans increases, the cost of loans--that is, the interest rate--decreases. Thus,
a low price level induces consumers to save, which in turn drives down the interest
rate. A low interest rate increases the demand for investment as the cost of
investment falls with the interest rate. Thus, a drop in the price level decreases
the interest rate, which increases the demand for investment and thereby increases
aggregate demand.

The third reason for the downward slope of the aggregate demand curve is exchange-
rate effect. As the price level falls the interest rate also tends to fall. When
the domestic interest rate is low relative to interest rates available in foreign
countries, domestic investors tend to invest in foreign countries where return on
investments is higher. As domestic currency flows to foreign countries, the real
exchange rate decreases because the international supply of dollars increases. A
decrease in the real exchange rate has the effect of increasing net exports because
domestic goods and services are relatively cheaper. Finally, an increase in net
exports increases aggregate demand, as net exports is a component of aggregate
demand. Thus, as the price level drops, interest rates fall, domestic investment in
foreign countries increases, the real exchange rate depreciates, net exports
increases, and aggregate demand increases.