Question

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Based on the AS-AD framework, explain and demonstrate the effect of the following situations on the...

Based on the AS-AD framework, explain and demonstrate the effect of the following situations on the equilibrium income and price levels

i)   An increase in the cost of imported goods that are used as inputs for domestically produced products.

Solutions

Expert Solution

Pressures for inflation to rise or fall are shown in the AD/AS framework when the movement from one equilibrium to another causes the price level to rise or to fall.

Redistribution effect: if the import duty causes an increase in the price of domestically produced goods, it amounts to redistribution of income between the consumers and producers in favour of the producers. ... This higher spending within the country may cause an expansion of domestic income and employment.

First, exports boost economic output, as measured by gross domestic product. 3 They create jobs and increase wages. Third, countries with high import levels must increase their foreign currency reserves. That's how they pay for the imports 5 That can affect the domestic currency value, inflation, and interest rates.

Growth and recession in the AD/AS model

We can examine both long-term and short-term changes in gross domestic product, or GDP, using the AD/AS model. In an AD/AS diagram, long-run economic growth due to productivity increases over time is represented by a gradual rightward shift of aggregate supply. The vertical line representing potential GDP—the full-employment level of gross domestic product—gradually shifts to the right over time as well. You can see this effect in AD/AS diagram A below, which shows a pattern of economic growth over three years.

However, the factors that determine the speed of this long-term economic growth rate—like investment in physical and human capital, technology, and whether an economy can take advantage of catch-up growth—do not appear directly in an AD/AS diagram.

In the short run, GDP, falls and rises in every economy because the economy dips into recession or expands out of recession. When an AD/AS diagram shows an equilibrium level of real GDP substantially below potential GDP—as is shown within the diagram below at equilibrium point \text{E0}E0start text, E, 0, end text—it indicates a recession. On the opposite hand, in years of resurgent economic process the equilibrium will typically be on the brink of potential GDP—as it's at equilibrium point \text{E1}E1start text, E, 1, end text.

Unemployment within the AD/AS diagram

We can examine two differing types of unemployment using an AD/AS diagram—cyclical unemployment and therefore the natural rate of unemployment. Cyclical unemployment bounces up and down consistent with the short-run movements of GDP. The long-term, baseline level of unemployment that happens year in and year out, however, is named the natural rate of unemployment.

The natural rate of unemployment is decided by how well the structures of market and government institutions within the economy cause an identical of workers and employers within the market . Potential GDP can imply different unemployment rates in several economies, counting on the natural rate of unemployment for that economy.

In an AD/AS diagram, cyclical unemployment is shown by how close the economy is to the potential or full-employment level of GDP. Take another check out the AD/AS diagram above. Relatively low cyclical unemployment for an economy occurs when the extent of output is on the brink of potential GDP, as at the equilibrium point \text{E1}E1start text, E, 1, end text. On the opposite hand, high cyclical unemployment arises when the output is substantially to the left of potential GDP on the AD/AS diagram, as at the equilibrium point \text{E0}E0start text, E, 0, end text.

The factors that determine the natural rate of unemployment aren't shown separately within the AD/AS model, although they're implicitly a part of what determines potential GDP, or full-employment GDP, during a given economy.

Inflationary pressures within the AD/AS diagram

Inflation fluctuates within the short run, and better inflation rates typically occur either during or simply after economic booms. for instance , the most important spurts of inflation within the US economy during the 20th century followed the wartime booms of war I and war II. On the opposite hand, rates of inflation generally decline during recessions.

The AD/AS framework implies two ways in which inflationary pressures may arise. One possible trigger is that if aggregate demand continues to shift to the proper when the economy is already at or near potential GDP and financial condition , thus pushing the macroeconomic equilibrium into the steep portion of the mixture supply curve. Let's check out diagram A, on the left below. during this diagram, you will see a shift of aggregate demand to the proper . The new equilibrium \text{E1}E1start text, E, 1, end text is at a better price index than the first equilibrium \text{E0}E0start text, E, 0, end text. during this situation, the mixture demand within the economy has soared so high that firms within the economy aren't capable of manufacturing additional goods because labor and physical capital are fully employed, then additional increases in aggregate demand can only end in an increase within the price index .

The two graphs show how a shift in aggregate demand or supply can cause inflationary pressure. The graph on the left shows two aggregate demand curves to represent a shift to the proper . The graph on the proper shows two aggregate supply curves to represent a shift to the left.

Another source of inflationary pressures may be a rise in input prices that affects many or most firms across the economy—perhaps a crucial input to production like oil or labor. this example can cause the mixture supply curve to shift back to the left. In diagram B above, the shift of the SRAS curve to the left also increases the worth level from \text{P0}P0start text, P, 0, end text at the first equilibrium \text{E0}E0start text, E, 0, end text to a better price index of \text{P1}P1start text, P, 1, end text at the new equilibrium \text{E1}E1start text, E, 1, end text. In effect, the increase in input prices ends up—after the ultimate output is produced and sold—being passed along within the sort of a better price index for outputs.

An AD/AS diagram shows only a one-time shift within the price index .

The aggregate demand/aggregate supply, or AD/AS, model is one among the elemental tools in economics because it provides an overall framework for bringing economic factors together in one diagram.

We can examine long-run economic process using the AD/AS model, but the factors that determine the speed of this long-term economic process rate don't appear directly within the AD/AS diagram.

Cyclical unemployment is comparatively large within the AD/AS framework when the equilibrium is substantially below potential GDP and comparatively small when the equilibrium is near potential GDP.

The natural rate of unemployment—as determined by the market institutions of the economy—is built into potential GDP, but doesn't otherwise appear in an AD/AS diagram.


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