Question

Draw a basic aggregate demand curve and aggregate supply graph (with LRAS constant) that shows the economy in the long-run equilibrium.

Assume that there is a large increase in demand for Saudi exports. Show the resulting short-run equilibrium on your graph. In this short-run equilibrium, is the unemployment rate likely to be higher or lower than it was before the increase in the exports? Briefly explain. Explain how the economy adjusts back to long-run equilibrium. When the economy has adjusted back to long-run equilibrium, how to have the values of each of the following changes relative to what was before the increase in exports:

1. The real GDP
2. The price level
3. The unemployment rate.

Answer 1

Answer :

Let the economy be initially in the long-run equilibrium, producing Y_o = Y_f output and the price level is P₀. When exports rise, AD curve shifts up from AD to AD'. In the short-run, we will have a new equilibrium with higher real GDP (Y), which is higher than the full employment level of output and higher price P₁ as shown in the short-run graph. The unemployment rate will fall in the short-run because of higher aggregate demand.

So short-term impact will be as follows:

i): Real GDP : Increase
ii): Price level : Increase
iii): Unemployment rate : decrease

However, in the long-run, because of higher demand, factor prices will go up and the SRAS curve will shift north-west as shown in the long-run graph below in such a way that real output is back to its full employment level, but price will continue to rise and it will get settled when SRAS = AD = LRAS. Since the real output will be back to full employment level, the long-run unemployment level will also be the same as the initial position.

To summarize, the long-run impact of increase in exports:

i): Real GDP : No change
ii): Price level : Increase
iii): Unemployment rate : No change

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