Question

Potential GDP is 24.3 mln and actual GDP is 24.1 mln. Price level is 98. 1. What phase of business cycle takes place in the short run (Expansion or Recession)? 2. Draw the graph for this short run economic situation and 3. Describe the problems (changes in macroeconomic variables: GDP, Unemployment and Price level) 4. Explain the appropriate monetary policy to bring the economy back to its long run Macroeconomic equilibrium. What tools would CB will use? 5. How will macroeconomic variables change?

Answer 1

1. In our question, the actual output is less than the potential output (24.1<24.3) – this leads to a situation of recession in the short run in the economy. The difference between the two output levels is known as the Recessionary Gap.

2. In the given diagram below, in the short-run there is a situation of recession, such that the actual level of output is less than the full employment level of output (YA < YF). The short-run aggregate demand curve (SRAD1) and short-run aggregate supply curve (SRAS) intersects at equilibrium point E1. With the equilibrium prices at 98.1.

3. During such a situation of recession, the short-run real production is less than the actual production leading to a fall in GDP. In such times there more tendency of firms to cut jobs and shut down due to economic losses leading to increase in unemployment. This leads to a fall in income that affects the purchases in the economy. Now people spend less that directly affects the overall prices. Thus inflation levels fall as well.

4. To correct the situation of Recession, the central bank would increase money supply and lower down the interest rates. Once the interest rates are lowered, it reduces the loan interest payments and consumers are able to use more of their income. This also encourages firms to increase investment. With this the aggregate demand increases and shifts the AD curve rightwards to SRAD2. With this shift the equilibrium in the long-run moves to E2; out-put levels move becomes full-employment level; however there is an increased in prices leading to demand pull inflation.