Question

Suppose an economy experiences an increase in exports. a) Show graphically using AD-AS model how the price level and output are affected in the long-run. b) Can the government use monetary policy to offset the effects on price level and output, explain.

Answer 1

(a)

An increase in exports increases net exports (= exports - imports), which increases aggregate demand ceteris paribus. This shifts AD curve rightward, increasing both price level and real GDP in short run, causing a short-run expansionary gap.

In the long run, higher price level will increase inputs costs, raising production costs. Firms will lower output, decreasing aggregate supply. SRAS shifts leftward, intersecting new AD curve at further higher price level and real GDP being restored to the potential GDP.

In following graph, AD0, LRAS0 and SRAS0 are initial aggregate demand, long-run aggregate supply and short-run aggregate supply curves intersecting at point A with initial price level P0 and real GDP (potential GDP) Y0. When government spending increases, AD0 shifts right to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1. Short run expansionary gap is (Y1 - Y0).

In long run, SRAS0 shifts left to SRAS1, intersecting AD1 at point C with further higher price level P2 and restoring real GDP to potential GDP level Y0.

(b)

To prevent inflation, Central Bank (not government, since government only sets fiscal policy) can use contractionary monetary policy, by decreasing money supply. This can be done by open market sale of government securities, and/or by increasing discount rate, and/or by increasing reserve ratio. Lower money supply increases interest rate, which decreases investment, thus reducing aggregate demand.