Question

Using AD/AS model and diagrams, discuss the short-run and long-run impacts of the following events
on the price level and output of the domestic economy (starting from the full-employment level):
a. A rise in oil prices
b. An increase in tourism

Answer 1

In each graph, AD0, LRAS0 and SRAS0 are initial AD, long run Aggregate Supply curve and short run Aggregate Supply curves intersecting at point A with initial long run equilibrium price level P0 and real GDP (= Potential GDP) Y0.

(a) When oil price rises, cost of inputs and production rise, so firms decrease production and output. Aggregate supply falls, shifting the short run AS curve leftward, increasing price level and decreasing output (known as Stagflation). However, in the long run as price and wage expectations adjust, aggregate demand rises, shifting ADcurve rightward until equilibrium is restored at potential GDP level but at a further higher price level. In following graph, AD0 & SRAS0 are initial aggregate demand & short run aggregate supply curves intersecting at point A with initial price level P0 and output Y0. As firms lower production, SRS0 shifts left to SRAS1, intersecting AD0 at point B with higher price level P1 and lower output Y1. In long run, as AD0 shifts right to AD1, it intersects SRAS1 at point C with real GDP being restored to Y0 but price level being further higher at P2.

(b) Increase in tourism is equivalent to an increase in exports, which will increase aggregate demand and shift AD curve toward right, increasing both price level and real GDP which gives rise to an inflationary gap in short run. In the long run, higher price level will increase cost of input, so firms will decrease output and aggregate supply will reduce, shifting SRAS to left, and new long run equilibrium is at a further higher price but real GDP will be equal to potential GDP, eliminating short run inflationary gap. In following graph, as AD0 shifts right to AD1, it intersects SRAS0 at point B with higher price level P1 and higher real GDP Y1, causing inflationary gap equal to (Y1 - Y0) in short run. In long run, as SRAS0 shifts left to SRAS1, it intersects AD1 & LRAS0 at point C with still higher price P2 and real GDP is restored to potential GDP of Y0, eliminating the short run inflationary gap.