Question

I. Explain whether each of the following events shifts the AS, LRAS, AD, both, or neither. For each event that does shift a curve, use a diagram to illustrate the effect on the economy.  

A. Households decide to save a larger share of their income.   

B. Florida orange groves suffer a prolonged period of below-freezing temperatures.

C. Increased job opportunities overseas cause many people to leave the country.

D. Due to higher wage growth, many domestic companies outsource their products to outside of US.

II. Monetary Policy  

For each of the event below, show the short-run effects on output, price and unemployment and explain how the Fed should adjust the money supply and interest rates to stabilize output    

A. FED increases the money supply to stimulate economy from recession.

B. FED increased the fed fund rate from 0.25 to 1.25% to fight against the potential high inflation rate.

C. Without any intervention by FED, people holds more cash and banks hold more excess reserves due to market uncertainty.

III. Fiscal Policy  

For each of the event below, show the short-run effects on output, price and unemployment and explain how the Fed should adjust the money supply and interest rates to stabilize output    

A. President Bush’s tax cut the individual income tax by $2000 per household in 2003.

B. Federal government issues the treasury bonds to finance the war in Iraq, and sell them to U.S citizens.

C. Illinois state government increases income tax for the residents in Illinois to pay for education and pension deficits.

Answer 1

(I)

In each of the following graphs, initial long-run equilibrium is at point A where AD0 (aggregate demand), LRAS0 (long-run aggregate supply) and SRAS0 (short-run aggregate supply) curves intersect, with initial long-run equilibrium price level P0 and initial long-run real output (full-employment output) Y0.

(A) An increase in savings will decrease consumption spending, lowering aggregate demand, which will shift the AD curve to left in short run, which reduces both price level and output in short run. In following graph, decrease in aggregate demand shifts AD0 leftward to AD1, intersecting SRAS0 at point B with lower price level P1 and lower output Y1.

(B) Prolonged adverse weather will decrease harvest, lowering aggregate supply, which will shift the SRAS curve to left in short run, which increases price level and lowers output in short run. In following graph, decrease in aggregate supply shifts SRAS0 leftward to SRAS1, intersecting AD0 at point B with higher price level P1 and lower output Y1.

(C) People leaving the country will decrease labor force. This will decrease short run aggregate supply, and also decrease potential output. So both SRAS and LRAS will shift leftward, In following graph, SRAS0 shifts leftward to SRAS1 and LRAS0 shifts leftward to LRAS1. AD0 intersects SRAS1 and LRAS1 at point B with higher price level P1 and lower real (and potential) output Y1.

(D) Outsourcing causes unemployment in US market, thus lowering consumer income. Aggregate demand falls, which will shift the AD curve to left in short run, which reduces both price level and output in short run. In following graph, decrease in aggregate demand shifts AD0 leftward to AD1, intersecting SRAS0 at point B with lower price level P1 and lower output Y1.

NOTE: As per Answering Policy, 1st multi-part question is answered.