Question

1. Using the AD-AS diagram, draw an economy in long run equilibrium. Indicate output and price level as Y1 and P1.

1. Suppose a pandemic is affecting the economy and the Federal government invests heavily in diagnostic and anti-body testing, increasing government purchases by 10 billion. Indicate the effect on the economy using your diagram. Remember, decide which curve shifts and which direction. Indicate the new equilibrium with Y2 and P2.
2. In words, what happens to the economy given the increase in government purchases?
3. Show how the economy returns to long run equilibrium. Indicate this point as Y3 and P3.
4. In words, how and why did this shift occur? How do sticky prices or sticky wages play into the result?

Answer 1

(a)

Higher government purchase on COVID crisis management increases aggregate demand, shifting AD curve rightward, which increases both price level and real GDP in short run, thus causing a short-run inflationary gap.

In following graph, AD1, LRAS1 and SRAS1 are initial aggregate demand, long-run aggregate supply and short-run aggregate supply curves intersecting at point A with initial price level P1 and real GDP (potential GDP) Y1.

When government purchases increases, AD1 shifts rightward to AD2, intersecting SRAS1 at point B with higher price level P2 and higher real GDP Y2. Short run inflationary gap equals (Y2 - Y1).

(b)

In short run, price level is higher and real GDP is higher. Unemployment is lower.

(c)

In long run, SRAS1 shifts left to SRAS2, intersecting AD2 at point C with further higher price level P3, which restores real GDP to potential GDP level of Y1.

(d)

In the long run, increase in price level raises input prices, increasing production costs. Firms decreased output, lowering aggregate supply. Therefore, SRAS shifted leftward, intersecting new AD curve at further higher price level and real GDP being restored to the potential GDP.