Question

Consider the Canadian economy that is in long run equilibrium with output equal to Y*. Canada and the United States have established a new free trade agreement that results in a significant increase in goods and services imported into the United States from Canada. For the Canadian economy, answer the following questions. use separate diagrams for each question.

1 illustrates the initial equilibrium in a diagram using AD and AS model. explain the diagram

2. what kind of shock occurred aggregate demand or supply? show this in your diagram

3. Explain the process (self-adjusting process AD & AS without monetary policy) by which the economy will adjust back toward Y* in the long run. show in your diagram

Answer 1

1) Long run equilibrium at E has economy operating at its full employment level of output and this ensures that unemployment is at its natural rate. Labor demand equals labor supply and there are no shortages or surpluses. This happens at E where LRAS SRAS and AD all are intersecting

2) There is a significant increase in goods and services imported into the United States from Canada. This implies that for Canadian economy net exports are increased. This shifts AD to the right. At F there is an inflationary gap since output increases beyond its full employment level. Inflation is also increased. There is a aggregate demand shock (positive)

3) During the transition from short to long run there is an increase in nominal wage so that real wages remain unchanged. This raises cost of production and so aggregate supply is shifted to the left. Price level is increased further but output falls and returns to its original full employment level. This is the new long run equilibrium at G