Question

An international recession hits the EU and China. Predict its effect on the U.S. economy.

a) Show graphically the long-run levels of prices and GDP

b) Identify and illustrate what changes in the U.S economy

c) Analyze how the U.S. economy returns to a long-run equilibrium

Answer 1

Question:

a). Answer:

You can see the economy is in long-run equilibrium at the point E1. At this equilibrium point the equilibrium price and quantity are P1 and Q1.

Graph:

b). Answer:

An international recession hits the EU and China will decrease the import in these countries. When an international recession hits the EU and China will decrease export of the US and decreasing export will decrease net export. Decreasing net export will decrease AD and AD curve shift left from AD to AD2. The new equilibrium point is E2.

Graph:

c). Answer:

When AD decraese due to international recession hits the EU and China will decrease price level that will increase AD and increasing AD will shift AD right to AD3 that will increase price and it will creast a positive output gap. Due to this increasing AD increase price level and at the increasing price level worker will demand for more wages to compensate this price change (inflation) also. So, to get the benefits of increase price and increasing wage level producers will decrease production level (supply) that will shift SRAS left from SRAS1 to SRAS2. So, in the long-run the US economy will rich at the  long-run equilibrium at the equilibrium point E3.

Graph: