Question

Q1. Consider an economy in the United States, starting from the long-run equilibrium denoted as the point A. Use an aggregate demand and aggregate supply (AD-AS) diagram to show that the economy is in the long-run equilibrium. (Please label variables clearly)

a. If the U.S. currency becomes stronger (the value of a dollar increases), there is a change in international variables. How does this situation affect the AD-AS diagram? What will happen to the equilibrium price level, inflation, unemployment and real GDP in the short run? Is the economy experiencing an inflationary gap or a recessionary gap? Explain your answer. (Please write the new equilibrium point denoted as the point B)

b. From part (a), assume that neither the Fed nor the government imposes any policies to simulate the economy. According to the concept of self-correction, in the long run, what will happen in the economy? How is the economy being improved? Explain it in words and graphically, using AD-AS diagram? (Please write the new equilibrium point denoted as the point C). What will happen to the equilibrium price level, inflation, unemployment and real GDP?

c. From part (a), during the business cycle, how does the Fed use monetary policy to overcome the problems faced by the economy and AD-AS diagram? (Please write the new equilibrium point denoted as the point C). What will happen to the equilibrium price level, inflation, unemployment and real GDP?

d. From part (a), how does government use fiscal policy to maintain the level of full employment. What will happen to the equilibrium price level, inflation, unemployment and real GDP?

Please make a separate graph for each problem and explain them, thanks!

Also please note that it asks for what will happen to the equilibrium price level, inflation, unemployment and real GDP on each one.

Answer 1

a).

Consider the given problem here U.S. currency becomes stronger, => the value of a dollar increases with respect to other currency, => the exchange appreciate. So, as the exchange rate appreciate the U.S. people increase its import as the foreign goods are become cheaper to U.S. people and on the other hand U.S. export decreases as the Foreign people decrease its import of U.S. goods, => NX decrease, => AD decreases. So, the AD of the US decreases to AD2.

So, here the initial equilibrium was at “A” where AD1, SRAS1 and LRAS are equal. Now, as the US currency becomes stronger the AD shift left to AD2, => the new SR equilibrium is B where AD2 and SRAS1 are equal. So, the equilibrium output decreases to Y2 and the price also decreases to P2. So, the price level and inflation of US decreases on the other hand real GDP also decreases and unemployment increases in US.

b).

Now, let’s assume that neither the government nor the Fed took any policy, => as the price decreases the “expected price also starts falling” to catch up the actual price level. So, as the expected price starts adjusting the SRAS starts falling until a new LR equilibrium established.

So, here the new LR equilibrium is “B” where AD2, SRAS2 and LRAS are equal. So, here the price further decreases and the level of inflation also decreases. On the other hand the real GDP increases and the unemployment decreases.

c).

Now, let’s assume Fed decide to take monetary policy to overcome the problem, => here Fed must take expansionary monetary policy, => AD increases back to AD1 and the economy get back to the old LR equilibrium level “A” where AD1, SRAS1 and LRAS are equal.

So, here the price and the inflation increases on the other hand the real GDP also increases and the unemployment decreases.

d).

Now, let’s assume government use fiscal policy to maintain the level of full employment. So, the government must take the expansionary fiscal policy by either increasing “G=government spending” or decreasing tax “T=tax”, => AD increases back to AD1 and the economy get back to the old LR equilibrium level “A” where AD1, SRAS1 and LRAS are equal.

So, here the price and the inflation increases on the other hand the real GDP also increases and the unemployment decreases.