Question

In: Economics

3.)Use the AD-ASdiagram to describe the short-run and long-run impact on national income adn the price...

3.)Use the AD-ASdiagram to describe the short-run and long-run impact on national income adn the price level when (Illustrate you answers with graphs.):

a)An increase in the money supply.

b)An increase in government purchases.

c)An increase in taxes.

Solutions

Expert Solution

In each of the following graphs, 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 real GDP (which is equal to Potential GDP) Y0.

(a) Higher money supply will raise aggregate demand, shifting the AD curve to right, which raises price level and raises real GDP in short run, creating an inflationary (positive output) gap. In the long run, higher price level will raise the cost of inputs for firms, so firms will decrease output. Aggregate supply will fall, shifting the short run aggregate supply curve to left until long run equilibrium is reached at original level but at a further higher price level, restoring real GDP to the initial potential GDP level.

In following graph, a rise in aggregate demand shifts AD0 to right to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1, leading to inflationary gap equal to (Y1 - Y0). In the long run, aggregate supply decreases, shifting SRAS0 to left to SRAS1 until it intersects AD1 at point C with further higher price level P1 and real GDP being restored at potential GDP of Y0, eliminating the inflationary gap.

(b) An increase in government spending will raise aggregate demand, shifting the AD curve to right, which raises price level and raises real GDP in short run, creating an inflationary (positive output) gap. In the long run, higher price level will raise the cost of inputs for firms, so firms will decrease output. Aggregate supply will fall, shifting the short run aggregate supply curve to left until long run equilibrium is reached at original level but at a further higher price level, restoring real GDP to the initial potential GDP level.

In following graph, a rise in aggregate demand shifts AD0 to right to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1, leading to inflationary gap equal to (Y1 - Y0). In the long run, aggregate supply decreases, shifting SRAS0 to left to SRAS1 until it intersects AD1 at point C with further higher price level P1 and real GDP being restored at potential GDP of Y0, eliminating the inflationary gap.

(c) Higher personal income taxes will lower disposable income and consumption demand for individuals, and higher business taxes will lower net income of firms, therefore lowering investment demand which will decrease aggregate demand, shifting the AD curve to left, which will lower both price level and real GDP in short run, creating a recessionary (negative output) gap. In the long run, lower price level will lower the cost of inputs, so firms will raise production. Aggregate supply will rise, shifting the short run aggregate supply curve to right until long run equilibrium is restored at a further lower price level, restoring real GDP to the potential GDP level.

In following graph, a fall in aggregate demand shifts AD0 to left to AD1, intersecting SRAS0 at point B where AD1 intersects SRAS0 with lower price level P1 and lower real GDP Y1, giving rise to a recessionary gap equal to (Y0 - Y1). In the long run, aggregate supply increases, shifting SRAS0 to right to SRAS1 until it intersects AD1 at point C with further lower price level P1 and real GDP being restored at potential GDP of Y0, eliminating the recessionary gap.


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