Question

Answer the questions with an essay of not more than 300 words : 2. Explain the short run and long run effects of the following events on output and price level with the AD-AS diagram: a. tax cuts b. money supply increases c. an increase in the price of key imported inputs d. a natural disaster that destroys a significant portion of production capacity e. a major technological innovation

Answer 1

2. a) A tax cut increases disposable income of the consumer and thus increases demand for consumer expenditure. AD curve shifts to the right to AD2. As a result, price and output both rises in the short run as there is no shift in AS curve. However, in the long run, rise in price will induce firms to produce more. In the long run, AS curve shifts to the right to AS2. Price decreases eventually and output increases further. In figure, price returns to its position P1. However, effect on price in the long run depends on relative shift of AD and AS curve.

b) Increase in money supply is an expansionary monetary policy of the government. it has same effect as of tax cut (expansionary fiscal policy ). The short run and long run effect on AD and AS curve are the same as the tax cut. Increase in money supply increases cash in hands of people which induce them to spend more on goods and services. Hence, AD curve shifts to the right. consequently output increases creating an inflationary effct in the economy. However, in the long run, increase in output offsets the inflationary effect and reduces the price level.

c) Increase in the price of the key imported inputs raises the cost of production. Thus, AS curve is likely to fall in the short run. Increase in product price is like an indirect tax, which reduces the consumption demand in the long run. Although price increases in the short run, it drops in the long run. Similar effect on output is observed.

d) d) A natural disaster, which destroys the production capacity of an economy significantly, results in drop in total output of the economy. Drop in output raises price of the products that reduces consumption demand and further investment demand until there is an improvement in production capacity.

e) A major technological innovation raises aggregate supply and output in the economy. Technologcal innovation raises production capacity of the economy. Therefore, increase in supply shifts AS curve rightward , which reduces price of the product in the short run. In the long run, aggregate demand increases due to increase in income . Eventually price starts to increase again with increase in output in the long run.