Question

Use the aggregate demand/aggregate supply framework to answer the following questions:

(a) A sharp decline in the stock market due to an increase in corporate bankruptcies leads to a decline in consumer and business confidence. What effect would you expect this shock to have on output and inflation in the short-run?
(b) The US government decides to lower military expenditures to reduce the budget deficit. What effect would you expect this shock to have on output and inflation in the shortrun?
(c) State and local governments increase infrastructure spending on highways and bridges boosting potential output. What effect does this shock have on output and inflation in the short-run? What effect does this shock have on output and the inflation in the long-run if monetary policy does not respond?
(d) A surge in violence in the Mideast causes a temporary spike in global oil prices. What effect would you expect this shock to have on output and inflation in the short-run?
(e) A temporary tax rebate is enacted by Congress in an effort to boost reelection prospects. What effect would you expect this shock to have on output and inflation in the shortrun?

Answer 1

AD = C+ I+ G+ NX

a) A sharp decline in the stock market due to an increase in corporate bankruptcies leads to a decline in consumer and business confidence would cause the aggregate demand curve to be affected i.e AD will decrease as investment will fall .So given the initial output and price , the A sharp decline in the stock market due to an increase in corporate bankruptcies leads to a decline in consumer and business confidence will cause the AD curve to shift left causing the output and inflation to fall in short run given the aggregate supply curve position .

b) The US government decides to lower military expenditures to reduce the budget deficit will cause the aggregate demand to be affected , AD will decrease as G will fall .This will cause the AD curve to shift left causing a fall in output and inflation level .

c) Increased expenditure by state would result in increased aggregate demand as G increases causing the AD curve to shift right such that output and inflation increases in short run . If monetary policy does not respond in long run then output will return to its initial level while the inflation will rise .

d) A surge in violence in the Mideast causes a temporary spike in global oil prices which will cause the aggregate supply to fall as oil is used as input in production , used in transportation so cost will increase causing the aggregate supply to fall . SO AS curve will shift left such that the output will fall and inflation will increase given the aggregate demand curve .

e) A temporary tax rebate is enacted by Congress in an effort to boost reelection prospect will increase the disposable income and therefore the consumption expenditure by the consumers so aggregate demand will increase causing the AD curve to shift right given the supply curve . SO output and inflation will increase in the short run .