Question

For each of the following, use the AD-AS diagram to show the short-run and longrun effects on output and inflation (assuming “self-correction”, i.e. no “stabilization policy”). Assume that the economy starts in long-run equilibrium.

a) The government reduces taxes.

b) The Fed tightens monetary policy.

c) Oil prices drop sharply and unexpectedly.

Answer 1

Ans.

a) In short run, a reduction of taxes will lead to increase in disposable income of the households increasing consumption spending which will increase the aggregate demand for the goods and services shifting aggregate demand curve to the right from AD to AD'. This will lead to increase in price level from P to P' and output from Y to Y'.

In long run, increase in price level will make workers to demand more wages increasing cost of production leading to decrease in aggregate supply shifting it leftwards from AS to AS'. This will move the output back to full employment level Y and increase the price level further to P".

b) In short run, contractionary monetary policy will lead to increase in interest rate leading to increase in cost of borrowing which decreases investment spending decreases aggregate demand for goods and services. This shifts the aggregate demand curve leftwards from AD to AD'. This will decrease the price level from P to P' and output from Y to Y'.

In long run, decrease in price level will lead to decrease in cost of production inducing production. This will increase the aggregate supply curve from AS to AS' decreasing prices further to P" and output back to full employment level Y.

c) Decrease in oil prices leads to decrease in cost of production increasing aggregate supply of goods and services shifting aggregate supply curve to the right from AS to AS'. This will decrease the price level from P to P' and output from Y to Y'.

In long run, decrease in price level increases real income of the workers increasing cost of production which will decrease the aggregate supply shifting the curve leftwards from AS' to AS. This will decrease output from Y' back to full employment level Y and increasing price level back to P.

* Please don’t forget to hit the thumbs up button, if you find the answer helpful.