Question

1. For each of the following events, explain the short-run and long-run effects on output and the price level, assuming policymakers take no action using a AS-AS-LRAS graph. (8 points)

a. The stock market declines sharply, reducing consumers’ wealth.

b. The federal government increases spending on national defense.

c. A technological improvement raises productivity.

d. A recession overseas causes foreigners to buy fewer U.S. goods and services.

e. Using AS-AD-LRAS graph, explain the consequences of the budget deficit on output and price level. Assuming the government borrow money from the rest of worlds, and needs to pay it back in the future.

Answer 1

A) This is a likely to reduce the consumption expenditure and therefore the aggregate expenditure. AD will shift to the left and in the short run there will be a reduction in the general price level and the real GDP. In the long run however aggregate supply will shift to the right and real GDP will return towards long run equilibrium level while price level will fall further.

B) This is a likely to increase government's expenditure and therefore the aggregate expenditure. AD will shift to the right and in the short run there will be a increase in the general price level and the real GDP. In the long run however aggregate supply will shift to the left and real GDP will return towards long run equilibrium level while price level will rise further.

C) Production is increased and therefore the short run aggregate supply curve SRAS will shift to the right. In the short run the price level decreases and the real GDP increases. However in the long run there will be a leftward shift of the aggregate supply curve which will raise the price level and bring the GDP back to its long run equilibrium level.

D) This is a likely to reduce the net exports expenditure and therefore the aggregate expenditure. AD will shift to the left and in the short run there will be a reduction in the general price level and the real GDP. In the long run however aggregate supply will shift to the right and real GDP will return towards long run equilibrium level while price level will fall further.