Question

Assume the economy is operating at potential GDP. In writing and in a graph, explain how each of the events below will affect the equilibrium price level, aggregate output, and the unemployment rate in the United States in the short-run. Be sure to analyze each event independently.

Congress passes a new budget that decreases taxes and increases government spending on infrastructure.

Due to higher interest rates, business firms decrease investment spending.

U.S. productivity declined for the third month in a row.

Due to the glut of oil on world markets, oil prices declined.

Answer 1

In each graph, AD0, SRAS0 and LRAS0 are initial aggregate demand, short run aggregate supply and long run aggregate supply curves intersecting at point A with initial price level P0 and real GDP (= potential GDP) Y0.

(1) Lower taxes increase consumption demand, which along with an increase in government spending increases the aggregate demand. Higher aggregate demand shifts AD curve rightward, increasing both price level and real GDP, causing an inflationary gap. In following graph, as AD increases, AD0 shifts right to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1, creating inflationary gap equal to (Y1 - Y0).

(2) When investment demand decreases, the aggregate demand falls. Lower aggregate demand shifts AD curve leftward, lowering both price level and real GDP, causing a recessionary gap. In following graph, as AD decreases, AD0 shifts left to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1, creating recessionary gap equal to (Y0 - Y1).

(3) When productivity falls, firm production and output also fall. Aggregate supply falls, shifting the short run AS curve leftward, increasing price level and decreasing output (known as Stagflation). In following graph, as firms lower production, SRS0 shifts left to SRAS1, intersecting AD0 at point B with higher price level P1 and lower output Y1.

(4) Lower oil prices reduce the cost of inputs, so firm production and output rise. Aggregate supply rises, shifting the short run AS curve rightward, decreasing price level and increasing output. In following graph, as firms raise production, SRS0 shifts right to SRAS1, intersecting AD0 at point B with lower price level P1 and higher output Y1.