Question

1. Using aggregate demand, short-run (SR) aggregate supply, and long-run (LR) aggregate supply curves, explain the process by which each of the following economic events will move the economy from an original LR (and SR) equilibrium (eq) to a new SR eq, and to a new LR (and SR) eq. Illustrate with diagrams.

1. There is a decrease in households’ wealth due to a decline in the stock market.
2. The government lowers taxes, leaving households with more disposable income.

Answer 1

a) There is decrease in overall wealth due to stock market crash. It will reduce willingness to pay by consumers and result in fall in aggregate demand in an economy from AD to AD1 which reduce price level as well as output level in short run.

​​​​​​In long run, producers will reduce their supply of goods and shift supply curve to its left because consumers are not willing to pay enough. Leftward shift in supply curve will reduce output level further while raise price level to its initial.

b) Government lowers taxes, leaving households with more disposable income. As people have more money in their hands, they will spend more raising aggregate demand and shift demand curve to its right from AD to AD1 which raise price level from P to P1 and raise output level from Y to Y1.

In long run, producers will raise their supply as consumers are willing to pay more. It will shift supply curve to its right which reduce price to its initial level and raise output level further.