Question

1. Starting from long-run equilibrium, use the basic (static) aggregate demand and aggregate supply diagram to show what happens in both the short run and the long run when there is an increase in consumer confidence. Explain your diagram.

Answer 1

An increase in consumer confidence increases consumption demand, which increases aggregate demand. AD curve will shift to right, increasing price level and increasing real GDP, giving rise to a short run expansionary gap in short run. In the long run, higher price level increases production cost so firms reduce production, lowering aggregate supply. SRAS shifts leftward, intersecting new AD curve at further higher price level but restoring original real GDP and removing the expansionary gap.

In following graph, initial 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 initial long-run equilibrium price level P0 and initial equilibrium real GDP (which is the full-employment GDP) Y0. When net exports rises, AD curve will shift rightward from AD0 to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1, giving rise expansionary gap of (Y1 - Y0) in short run. In long run, SRAS0 shifts left to SRAS1, intersecting AD1 at point C with further higher price level P2 and restoring real GDP to full-employment GDP level Y0, removing the expansionary gap.