Question

Beginning at long-run equilibrium use the AS-AD model to illustrate what happens to output and inflation in the short-run and the long-run when:

a) imports rise

b) the expected inflation rate rises

c) consumers experience a change in attitudes such that they consume a larger part of their income (rather than saving it)

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) Increase in imports will decrease net exports (= Exports - Imports), which will decrease aggregate demand, shifting AD curve leftward. In short run, this will decrease both price level and real GDP, causing a recessionary gap. In long run, lower price level will decrease the cost of inputs, so firms will increase production which will increase short run aggregate supply, shifting short run AS curve to right until new long run equilibrium occurs at a further lower price level but restoring real GDP to potential GDP level, removing 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). In long run, new equilibrium is at point C where higher aggregate supply shifts SRAS0 rightward to SRAS1, intersecting AD1 with still lower price level P2 and real GDP at Y0, removing recessionary gap.

(b) Increase in expected inflation rate will increase current consumption demand, increasing aggregate demand and shifting 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.

(c) When people consume higher portion of their income, Marginal propensity to consume rises, which increases consumption demand ceteris paribus, thereby increasing aggregate demand and shifting 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.