Question

Assume a contemporary Aggregate Demand Aggregate Supply model. Using graphs to support your analysis, determine the short-run and long run adjustments to real GDP and the price level when:

1) There is a decrease in foreign prices

2) There is a decrease in domestic interest rates

3) There is a decrease in taxes

4) There is a decrease in transfer payments

Answer 1

In each graph, 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 long-run equilibrium price level P0 and real GDP (= Potential GDP) Y0.

(1) A decrease in foreign price makes foreign goods cheaper compared to domestic goods, so import demand rises and export demand falls, lowering net exports and decreasing aggregate demand. AD curve will shift to left, lowering price level and lowering real GDP, causing a recessionary gap in short run. In the long run, lower price level lowers input costs, so firms raise production, increasing aggregate supply. SRAS shifts rightward, intersecting new AD curve at further lower price level but restoring original real GDP and eliminating recessionary gap.

In following graph, AD curve will shift leftward from AD0 to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1, with recessionary gap being equal to (Y0 - Y1) in short run. 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.

(2) A decrease in domestic interest rate increases domestic investment, increasing aggregate demand. AD curve will shift to right, increasing price level and increasing real GDP, causing an inflationary gap in short run. In the long run, higher price level raises input costs, so firms lower production, decreasing aggregate supply. SRAS shifts leftward, intersecting new AD curve at further higher price level but restoring original real GDP and eliminating inflationary gap.

In following graph, AD curve will shift rightward from AD0 to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1, with inflationary gap being equal to (Y0 - Y1) in short run. 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.

(3) Decrease in taxes increases disposable income and consumption (assuming personal income tax), or increases investment (assuming business income tax), either of which increases aggregate demand. AD curve will shift to right, increasing price level and increasing real GDP, causing an inflationary gap in short run. In the long run, higher price level raises input costs, so firms lower production, decreasing aggregate supply. SRAS shifts leftward, intersecting new AD curve at further higher price level but restoring original real GDP and eliminating inflationary gap.

In following graph, AD curve will shift rightward from AD0 to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1, with inflationary gap being equal to (Y0 - Y1) in short run. 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.

(4) Decrease in transfer payment decreases disposable income, which lowers consumption and decreases aggregate demand. AD curve will shift to left, lowering price level and lowering real GDP, causing a recessionary gap in short run. In the long run, lower price level lowers input costs, so firms raise production, increasing aggregate supply. SRAS shifts rightward, intersecting new AD curve at further lower price level but restoring original real GDP and eliminating recessionary gap.

In following graph, AD curve will shift leftward from AD0 to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1, with recessionary gap being equal to (Y0 - Y1) in short run. 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.