Question

1. In the AS-AD model, show graphically what would happen to the US economy in the short-run and in the
long-run if aliens doubled the amount of capital in our economy. Label the initial long-run equilibrium with A,
the short-run equilibrium with B, and the new long-run equilibrium with C.
P on the Y-axis; and Y on the X-axis.
2. In the AS-AD model, show graphically what would happen to the US economy in the short-run and in the
long-run if income tax rates increase. Label the initial long-run equilibrium with A, the short-run equilibrium
with B, and the new long-run equilibrium with C.
P on the Y-axis; and Y on the X-axis.

Answer 1

If Aliens doubled the amount of capital in the economy then the output will increase manyfold. The economy is initially at equilibrium at point A. The short-run aggregate demand curve SRAD and short-run aggregate supply curve SRAS meets the long run aggregate supply curve at point A and price is P and output Q.

Now Aliens come in. Because of increased capital, a positive supply shock the SRAS will shift to SRAS' at a lower price and higher output. The new output will be Q' and the price will be much lower at price P'. The equilibrium at this point will be B. Here, the SRAD and SRAS meet. The LRAS curve will also shift to the right because of increased capital supply. The new LRAS will be C.

2) The graph below shows the effect of increased taxes on the economy. Initially, the economy is at point A. The SRAD curve meets the SRAS and LRAS at this point the output is Q and the price is P in the economy.

The new US government increased the taxes which will lead to a leftward shift in the demand curve the new demand curve will be SRAD'. The SRAD' meets the SRAS at a lower price and lower output. The equilibrium is at point B and the price is down to P'. The output at this price is Q'. At this point, there is unemployment in the economy.

From this point due to unemployment, the wages will fall and there will be a positive supply shock in the market. This will shift the SRAS to SRAS' at a higher output and lower price. The equilibrium is at point C. The point where the SRAD' meets LRAS and SRAS'. The new price is P" and output is Q.