Question

The economy of Country X is at full employment.

(a) Draw a correctly labeled graph of the long-run aggregate supply, short-run aggregate supply, and aggregate demand curves, and show each of the following.

(i) Current price level, labeled  PL1

(ii) Current real output, labeled  Y1

(b) Assume that household income increases as a result of recent economic prosperity in Country X. On your graph in part (a), show the effect of the increase in household income on real output and price level.

(c) What will be the effect of the change identified in part (b) on unemployment in Country X?

(d) Will the change in real output shown in part (b) be smaller or larger in the presence of automatic stabilizers? Explain.

Answer 1

we know that the AD is the function of f(M/P, G, T) & AS is the function of f(P,Pe)

AD is downward sloping and AS is an upward sloping curve. The economy will at equilibrium where AD meets AS.

Hence the economy is in equilibrium at A

a)

LRAS is the long-run AS. It is vertical because of the classical assumption that in the long-run there will be always full employment level of output. Hence Y1 is the full employment level of output.

SRAS is upward sloping due to the assumption of sticky wages.=> infinite supply of labour => unemployment will be there.

Hence at A assume this is long-run equilibrium & hence LRAS also passes through A.Thus the equilibrium price is P1 which also equals the Pe and equilibrium output is Y1.

b)

now the money income increases of the consumer. => disposable income increases because of consumption = income - taxes. As a result, AD will shift rightward as at every price now the demand has been increased. Now the economy will move to point B in the short run. hence the real output will increases to Y2 as well as price level has been increased to P2.

c)

since, it is assumed that in the short run there is infinite supply of labour & as real GDP has been increased, employment will also be increased. Hence, unemployment reduces in the short-run.

But in the long as expected price is now lesser than the P2, hence there will be revision of the expectation. And as a result, AS will now shift upward till expected price and actual price becomes equal. hence in the long run economy will move to C and real GDP return to Y1 at full employment level & unemployment will be at again natural level.

Only price level will rise in the loong-run i.e. P3.

d)

automatic stabilizers means something which reduces the impact of fiscal policy on the real output. hence the name stabilizers. e.g. tax

In absence of tax we know that multiplier is given by 1/(1 - c), where c is MPC

in presence of tax, multiplier = 1/[1 - c(1 - t)], this is less than the above multiplier

hence in the presence of automatic stabilizers, change in the real output will be smaller.