Question

For each of the following, use the AD-AS diagram to explain the short-run and long-run effects on output and inflation. Assume that the economy starts in long-run equilibrium. a. Consumer confidence increases. b. A reduction in taxes. c. A decrease in the money supply by the Fed. d. A sharp, unexpected, increase in oil prices. e. A war increases government purchases.

Answer 1

a)

This economy was initially at long-run equilibrium, so its current output (Y1) was equal to its full employment output (Yf). As the result of an increase in one of the components of AD(i.e.Consumer confidence), the entire curve will increase (shift to the right). At the old price level, AD would exceed SRAS. This excess demand puts upward pressure on the price level until the economy assumes a new short-run equilibrium at a higher price level (PL2) and higher output (Y2). Because output has increased, the unemployment rate has decreased

b) A reduction in taxes leads to an increase in disposable income, which will increase household consumption and saving. An increase household consumption will increase aggregate demand, real GDP, and the price level.

This economy was initially at long-run equilibrium, so its current output (Y1) was equal to its full employment output (Yf). As the result of an increase in one of the components of AD(i.e.Consumer confidence), the entire curve will increase (shift to the right). At the old price level, AD would exceed SRAS. This excess demand puts upward pressure on the price level until the economy assumes a new short-run equilibrium at a higher price level (PL2) and higher output (Y2). Because output has increased, the unemployment rate has decreased

c) The decrease in the money supply is mirrored by an equal decrease in the nominal output, otherwise known as Gross Domestic Product (GDP). In addition, the decrease in the money supply will lead to a decrease in consumer spending. This decrease will shift the aggregate demand curve to the left.

This economy was initially at long-run equilibrium, and its current output (Y1) was equal to its full employment output (Yf). As the result of decrease in consumer spending., AD curve has decreased (shifted to the left). At the old price level, SRAS would exceed AD. This puts downward pressure on the price level until the economy assumes a new short-run equilibrium at a lower price level (PL2) and lower output (Y2). Because output has decreased, the unemployment rate has increased.

d) A marked rise in oil prices will contribute to a higher inflation level. This is because transport costs will rise leading to higher prices for many goods. This will be cost-push inflation which is quite different to inflation caused by rising aggregate demand/excess growth.

Consumers will see a fall in discretionary income. They face higher transport costs, but don’t have the compensation of rising incomes. Higher oil prices can lead to slower economic growth – particularly a problem if consumer spending is weak.

This economy was initially at long-run equilibrium, and its current output (Y1) was equal to its full employment output (Yf). Something has changed in the economy making output more costly for producers, such as increased regulation. At the old price level, AD would exceed SRAS. This puts upward pressure on the price level until the economy assumes a new short-run equilibrium at a higher price level (PL2) and lower output (Y2). Because output has decrease, the unemployment rate has increased.

e) Increased government spending due to war is likely to cause a rise in aggregate demand (AD).

This economy was initially at long-run equilibrium, so its current output (Y1) was equal to its full employment output (Yf). As the result of an increase in one of the components of AD(i.e. Government spending), the entire AD curve will increase (shift to the right). At the old price level, AD would exceed SRAS. This excess demand puts upward pressure on the price level until the economy assumes a new short-run equilibrium at a higher price level (PL2) and higher output (Y2). Because output has increased, the unemployment rate has decreased