Please explain the law of demand in words, and give an example of how such a law can be examined in a real-life scenario.
The law of demand for a normal good states that as the price of a good increases, the quantity that will be demanded by the public will decrease. This makes a lot of intuitive sense due to the fact that as the price goes up, generally, you do not want to consume more of a particular good in question. A real-life scenario of the law of demand in action would be a summer ice cream. Say you buy one ice cream a night given a constant income in the summer. That would be a demand of 7 units a week. However, say that the price rises of this particular ice cream. Given your income has stayed constant, now you decide you can only afford 5 per week. Thus, this is the law of demand in action, as the price of a good goes up, given a constant income/other factors, the quantity demanded must go down.
Assume that everyone in a particular economy cares a lot about two goods, milk and bread. As the price of milk goes up, the quantity demanded of bread decreases, as well as the quantity demanded of milk, per the law of demand? Would this make milk and bread complements, substitutes, or no relationship at all? Explain.
Because as the price of milk goes up, and the quantity demanded of bread goes down in parallel fashion to that of milk, this makes milk and bread COMPLEMENTS. In an economic term, complements are known as goods that are typically consumed TOGETHER. Assuming both goods are normal goods, as the price of one good that is a complement with another goes up, the quantity demanded of both goods will both go down (in the same direction), and vice versa in the opposite situation.
Assume that the current financial (economic) situation in the USA is in an inflationary gap? Please tell me (1) what this means? And (2) what would the Federal Reserve do in order to dampen inflation? (3) What would be the net result of such an action?
(1) An inflationary gap is when the actual GDP (currently) is higher than potential GDP, meaning that the economy is overheated and actually producing more than it should be at "Full Employment" (~5% unemployment, the natural rate). (2) In order to dampen inflation and return GDP back to its potential level, the Federal Reserve would want to undergo CONTRACTIONARY MONETARY POLICY. (3) The net result of Contractionary Monetary Policy would be a leftward shift in the Nominal Money Stock circulating in the USA. (Vault cash/ cash held by the public). This would cause an increase in interest rates, which would cause less money to be held in people's "pockets" and into savings accounts instead, as the tradeoff is much higher to now earn interest on that money instead. This increase in interest rates would also cause investment spending to decrease, as the cost of borrowing money would increase. Because GDP is defined as = Consumption + Investment + Gov't Spending+ Net Exports, as investment decreases, so does GDP, thus returning GDP to its potential level and avoiding an overheated economy.