Question

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.

Answer 1

In following graph, 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 price level P0 and real GDP (= Potential GDP) Y0.

(a) An increase in money supply will increase aggregate demand, shifting the AD curve rightward, which increases both price level and real GDP in short run, giving rise to an inflationary gap. In the long run, higher price level will increase the cost of inputs, so firms will lower production and output. Aggregate supply decreases, shifting the short run aggregate supply curve leftward until long run equilibrium is restored at a further higher price level, restoring real GDP to the potential GDP level.

In following graph, an increase in aggregate demand shifts AD0 rightward and economy moves to point B where AD1 intersects SRAS0 with higher price level P1 and higher real GDP Y1, creating an inflationary gap equal to (Y1 - Y0). In the long run, aggregate supply falls, shifting SRAS0 leftward 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 increase aggregate demand, shifting the AD curve rightward, which increases both price level and real GDP in short run, giving rise to an inflationary gap. In the long run, higher price level will increase the cost of inputs, so firms will lower production and output. Aggregate supply decreases, shifting the short run aggregate supply curve leftward until long run equilibrium is restored at a further higher price level, restoring real GDP to the potential GDP level.

In following graph, an increase in aggregate demand shifts AD0 rightward and economy moves to point B where AD1 intersects SRAS0 with higher price level P1 and higher real GDP Y1, creating an inflationary gap equal to (Y1 - Y0). In the long run, aggregate supply falls, shifting SRAS0 leftward 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) An increase in taxes will decrease disposable income and consumption demand, thus lowering aggregate demand, shifting the AD curve leftward, which decreases both price level and real GDP in short run, giving rise to a recessionary gap. In the long run, lower price level will decrease the cost of inputs, so firms will increase production and output. Aggregate supply increases, shifting the short run aggregate supply curve rightward until long run equilibrium is restored at a further lower price level, restoring real GDP to the potential GDP level.

In following graph, a decrease in aggregate demand shifts AD0 leftward and economy moves to point B where AD1 intersects SRAS0 with lower price level P1 and lower real GDP Y1, creating a recessionary gap equal to (Y0 - Y1). In the long run, aggregate supply rises, shifting SRAS0 rightward 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.