Question

Draw the AD-AS curves marking the axes and showing the short term equilibrium. Describe when it is a macro failure.

Answer 1

A short term equilibrium occurs where Aggregate demand and Aggregate supply curves meet at a common aggregate price level to determine the equilibrium GDP. This short term equilibrium may not necessarily coincide with the long run eqquilibrium that is determined when AS , AD and Long run AS all meet at the same price level and economy is at its full employment potential level of GDP.

The aim of the government and the Fed is to establish internal and external balance in the economy. In case there are imbalances and the economy loses its ability to resurrect itself in due course of time without any external stimulus, there are macroeconomic failures. Government has to increase its spending or reduce taxes and Fed has to increase money supply to bring the economy out of the macroeconomic failure. A tight fiscal and monetary policy is required in the opposite case where short run equilibrium generates a GDP that is higher than potential one.