Question

1. Describe the effects of each of the following events on the US economy (i.e. What may happen to the price? To the real output?). Explain briefly what cause these effects (i.e. What happens to determinants of AD or AS or both? Why? ).Illustrate your answers in given AD-AS diagrams. Label your diagrams and changes carefully.

1. Potential middle-east war pushed the price of oil higher.

b. Technology innovation results in a more efficient production method of goods.

c. Stock market crash in the early 2000s wiped out a significant amount of wealth of American households.

Answer 1

a.

• Oil prices affect the economy through the input prices that producers have to pay to make the goods and services that people buy.When there are oil price shocks in the economy the price of oil gets higher and eventually passes on to the consumer in the form of higher prices for the goods and services that use oil in their production and distribution.
• An oil price shock which results from a potential middle east war causes an increase in input costs for businesses. Such geo-political risks gets incorporated in input costs of businesses.This raises price level for goods and services. At the original price level, aggregate demand equals aggregate supply at B. As the price levels rise, then consumers experience a reduction in their real wealth and consumption falls. Also, the rising domestic price level discourages foreigners from buying US goods and services and exports fall.
• All of these components add up to a reduction in the aggregate quantity demanded as the price level rises.So if steps are taken to raise aggregate demand to Q then it means movement along the LRAS to the new equilibrium point with a higher price level and unchanged output.

See the diagram attached below -

b.A technological innovation that leads to efficient use of factors of production can have following affects –

• raise labour productivity
• Lowers capital to output ratio i.e. less capital required to produce output.
• Reduction in input costs

This increases business’s returns and profits.It also builds up optimism in market that raises investment activity.In short run Aggregate supply curve the point shifts from B to Q shifts rightward causing prices to fall. Fall in prices makes domestic goods relatively cheaper to foreign goods thereby raising exports and pushing the aggregate demand to right. Overall affect is economy's output expands more than its natural level.

However in long term this raises prices as wages push up prices.

See the diagram attached below -

c.The stock market crash of 2000 wiped out wealth of American households thus reduction in savings.Reduction in savings reduces money supply thereby raising interest rates.At higher interest rates businesses do not find it profitable to undertake projects so investments fall.So short run aggregate supply point shifts leftward.This means prices rise in short run.

Moreover due to price rise and fall in the wealth of American households causes aggregate demand to shift leftwards.This causes output to fall. Such periods when prices are rising at the same time output is falling are known as stagflation i.e. inflation and stagnation together and is very painful for the economy.

See the change in LM curve and consequent change in AD in diagram attached below -