Question

The economy is initially at point A; where the economy is in both short and long run equilibrium (2.5 marks).
Then, the government increases its spending and the short run equilibrium is at point B (2.5 marks), and later the factor market reacts by rising wages and other factor prices and the economy reaches back to its potential GDP position at Point C (2.5 marks).
Then the price of oil skyrocketed and it pushes the economy into a recession and the economy is at a new equilibrium Point D (2.5 marks).
Using the AS-AD model as your conceptual framework, clearly describe in wordshow the economy moves from its initial long-run equilibrium (Point A) to Point B to Point C and to Point D. Specifically, describe any shifts of the AS, AD and LAS curves, indicating (i) whether or not there is an output gap at the points B, C and D and (ii) whether the output gap at each of these points is an inflationary gap or a recessionary gap.

Answer 1

Initially economy is at equilibrium point of a short run aggregate supply and aggregate demand curve cut the long run aggregate supply curve at potential output Y. Increase in government expenditure will shift the aggregate demand curve to the right and increases the output level and price level. Hence equilibrium will be at higher price and output Y1 at point B. Here there is a positive output gap from potential output. In this case there will be a inflationary pressure on the economy as aggregate demand is higher than the aggregate supply.

Responding to the increase in demand and price label there will be an increase in wages and input price hence the aggregate supply curve will shift to the left. Finally there will be an equilibrium at point C which cut the long run aggregate supply curve there will be no output gap. there will be neither inflationary nor deflationary pressure on the economy.

Finally there will be an increase in price level from the increase in the oil price. It will cause them for the shift in the aggregate supply curve to the left. It is so called the supply side shock hence there will be reduction in the output and increase in the price level known as stagflation. In such a case there will be inflationary pressure on the economy duty supply shock and negative output gap.