Question

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. Oil prices suddenly increase worldwide

B. The government raises the personal income tax

C. Firms expect an economic boom in the coming years

D. A country the US trades with experiences an economic boom

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)

Oil being an input, higher oil price will increase cost of inputs. Production cost will increase, so firms will reduce output. Aggregate supply will fall, shifting SRAS curve leftward, increasing price level and decreasing real GDP, thus causing Stagflation in short run, giving rise to a short-run negative output gap. The economy goes into a recession.

In long run, prices and wages adjust, hence aggregate demand will increase. AD curve will shift rightward, intersecting new SRAS curve at further higher price level, but restoring real GDP to potential GDP.

In following graph, 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. Higher wages shifts SRAS0 left to SRAS1, intersecting AD0 at point B with higher price level P1 and lower real GDP y1 in short run. In long run, AD0 shifts right to AD1, intersecting SRAS1 at point C with further higher price level P2 but real GDP restored at Y0.

(B)

Higher personal income tax lowers disposable income, which reduces consumption. 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.

(C)

When firms expect an economic boom, they increase investment, raising aggregate demand, which shifts 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 investment 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)

An economic boom in trading partner increases export demand, which increases net exports, in turn raising 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 export 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.