Question

1. Trace through the short-run, intermediate, and long-run effects of an increase in consumer wealth.  (Remember there are several AD determinants.  Be able to do this question for any of them—things like consumer optimism, consumer pessimism, decreases in wealth, decrease in household indebtedness, increase in household taxes, decreases in household taxes, increased excess capacity of capital, decreased excess capacity of capital, increases in the cost of maintaining capital, decreases in the cost of maintaining capital, increases in gov’t spending, decreases in gov’t spending, increases in income abroad, decreased value of currency, ETC).  No not use policy to offset the resulting business cycle. Include a graph and extended 4-step analysis.

1)start:

2)Shock:

3)Shift:

4)Result: Short Run

Intermediate

Long Run

Answer 1

An increase in consumer wealth will cause personal consumption expenditure to increase. Higher consumption will increase aggregate demand. AD curve will shift to right, increasing both price level and real GDP, causing expansionary gap in short run. Unemployment rate will decrease.

In the intermediate run, higher price level will increase wages and prices of inputs, increasing firms' production costs. Firms will reduce output, decreasing aggregate supply. SRAS shifts leftward, until new long run equilibrium is established at intersection of new AD curve at further higher price level but restoring real GDP to potential GDP. Unemployment rate will restore at original full-employment rate.

In following graph, initial long-run equilibrium is at point A where AD0 (aggregate demand), LRAS0 (long-run aggregate supply) and SRAS0 (short-run aggregate supply) curves intersect with long-run equilibrium price level P0 and long-run equilibrium real GDP (which is equal to potential GDP) Y0. As result of higher consumption, AD curve will shift rightward from AD0 to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real output Y1, with short run inflationary gap of (Y0 - Y1). In the long run, SRAS0 shifts left to SRAS1, intersecting AD1 at point C with further higher price level P2 and restoring real GDP to potential GDP level Y0.