Question

Suppose Potential GDP is $15 trillion. Further suppose that the short-run aggregate supply (SRAS) curve intersects the aggregate demand (AD) curve at a level of Real GDP of $18 trillion and a Price Level of 120 as measured by a price index

a. Draw the Aggregate Demand – Supply Graph for this situation. (Call this point A).

b. Is there an inflationary or a recessionary gap?

c. Assuming no fiscal policy is used, show the long run equilibrium by completing this graph. Show this long run result due to this short run macroeconomic situation in part b. (Call this point B).

d. Will nominal wages change between points A and B? Will they rise, fall, or stay the same?

e. For this question draw a separate graph (drawing the situation in part A of this question). Suppose that instead of the economy self adjusting, the correct fiscal policy in this situation is used. Complete the graph showing the new long run equilibrium after the correct fiscal policy is used in this situation.

Answer 1

a).

b). Since the current real GDP is greater than the potential level of GDP the econmy is having an inflationary gap.

c). If no fiscal or monetary policy is used , the economy will selft adjust. The inflatioanry gap has resulted in a higher price level and an increase in the output. The rise in the price will cause the real wage of workers to fall so they demand for a hike in the nominal wages. The increase in the nominal wages adds to the business cost of firms so as the cost of production increases the firm would cut the production. The short run aggregate supply decreases and shift to the left. The long run equilibrium point is denoted by point 'B'. The nominal wages have rised.

d).The nominal wage have rised.

e). If there is an government intervention they would use contractionary fiscal policy to eliminate the gap, that is either an increase in the taxes or decrease in the government spending. This will decrease the aggregate demand and eliminate the gap.