Question

Consider the Canadian economy that is in long run equilibrium with output equal to Y*. The United States economy goes into a major slowdown causing a significant decrease in goods and services shipped into the United States from Canada. For the Canada, answer the following questions:

A) What kind of shock occurred- aggregate demand or aggregate supply? Explain your answer.

B) Explain the how fiscal policies by government of Canada can be used to drive the economy back towards Y* in the long run. Explain the steps

Answer 1

Initially the economy is at its long run equilibrium where aggregate demand = short run supply (SRAS) curve = long run supply (LRAS) curve and output level is Y*. Economy is at its economic equilibrium of point B.

a) As US is facing economy slowdown which reduces the demand of Canadian goods into its economy which are exports for Canada and imports for US. It will reduce aggregate demand of Canada because aggregate demand and exports have positive relationship with each other. It will shift its aggregate demand from demand to new demand causing economic equilibrium to shift from point B to A where output level fall from Y* to Y and price level fall from P* to P. It is a kind of aggregate demand shock for Canadian economy.

b) To raise the aggregate demand, government of Canada will raise aggregate demand by adopting expansionary fiscal policy which raises government spending and reduces tax (raises disposable income). Both of the factors raise aggregate demand from New demand to demand curve again which shift economic equilibrium from point A to B again and raise output level again to Y*