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Use AD-AS model to analyze how shocks affect economic activity in short and long run.

For each shock:

1. Suppose the economy starts in the long run equilibrium. Illustrate changes that the shock will cause in the short run (using AD-SRAS). Explain why each curve shifts.
2. Determine how the price level and output will be affected in the short run.
3. Mark the output gap on the diagram. Is the output gap positive or negative? Is the economy is booming, or is it in a recession?
4. On the same diagram illustrate how the economy will adjust to the shock in the long run and explain the mechanism.
5. Determine how the price level and output will be affected in the long run

Consider the following shocks:

A. The government raises unemployment benefits

B. The central bank decides to raise the money supply; as a result, the interest rate in the economy goes down

C. The government increases its spending on national defense

D. There is a stock market crash and a pandemic causes households to stay home all the time; as a result, they reduce their consumption

Answer 1

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

(A)

An increase in unemployment benefits increases consumption, which increases aggregate demand, shifting AD curve rightward, increasing both price level and real GDP in short run, giving rise to a positive output gap. The economy starts booming.

In the long run, higher price level will increase prices of inputs, raising production costs. Firms will decrease output, reducing aggregate supply. SRAS shifts leftward, intersecting new AD curve at further higher price level but real GDP gets restored to the potential GDP.

In above graph, as consumption demand increases, AD0 shifts right to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1. Short run ouitput gap is (Y1 - Y0).

In long run, SRAS0 shifts left to SRAS1, intersecting AD1 at point C with further higher price level P2 and restoring real GDP to potential GDP level Y0.

(B)

An increase in money supply decraeses interest rate, which increases investment, in turn increasing aggregate demand, shifting AD curve rightward, increasing both price level and real GDP in short run, giving rise to a positive output gap. The economy starts booming.

In the long run, higher price level will increase prices of inputs, raising production costs. Firms will decrease output, reducing aggregate supply. SRAS shifts leftward, intersecting new AD curve at further higher price level but real GDP gets restored to the potential GDP.

In above graph, as consumption demand increases, AD0 shifts right to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1. Short run ouitput gap is (Y1 - Y0).

In long run, SRAS0 shifts left to SRAS1, intersecting AD1 at point C with further higher price level P2 and restoring real GDP to potential GDP level Y0.

(C)

An increase in government spending directly increases aggregate demand, shifting AD curve rightward, increasing both price level and real GDP in short run, giving rise to a positive output gap. The economy starts booming.

In the long run, higher price level will increase prices of inputs, raising production costs. Firms will decrease output, reducing aggregate supply. SRAS shifts leftward, intersecting new AD curve at further higher price level but real GDP gets restored to the potential GDP.

In above graph, as consumption demand increases, AD0 shifts right to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1. Short run ouitput gap is (Y1 - Y0).

In long run, SRAS0 shifts left to SRAS1, intersecting AD1 at point C with further higher price level P2 and restoring real GDP to potential GDP level Y0.

(D)

A decrease in consumption decreases aggregate demand, shifting AD curve leftward, decreasing both price level and real GDP in short run, giving rise to a short-run negative output gap. The economy goes into a recession.

In the long run, lower price level will decrease prices of inputs, raising production costs. Firms will raise output, increasing aggregate supply. SRAS shifts rightward, intersecting new AD curve at further lower price level and real GDP being restored to the potential GDP.

In above graph, as consumption demand decreases, AD0 shifts left to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1. Short run Recessionary gap is (Y0 - Y1).

In long run, SRAS0 shifts right to SRAS1, intersecting AD1 at point C with further lower price level P2 and restoring real GDP to potential GDP level Y0.