Question

Explain what will happen as a result of the following events. In each case, draw an aggregate demand and short-run aggregate supply diagram showing the initial equilibrium output level (Y0) and price level (P0). Show any changes and indicate the final equilibrium output level and price level.

A. The economy is operating near full capacity. Now environmental pollu¬tion standards are tightened substan¬tially.

B. The economy is operating near full capacity. An import tax (tariff) is imposed on foreign consumer goods, and the central bank tries to maintain the interest rate.

Answer 1

Wehn pollution standards are tightened, it is costlier for firms to produce the original equilibrium of output and hence, they decrease supply. As a result, Aggregate Supply shifts to the left, increasing the price level and decreasing the equilibrium output.

As a result of the import tariff, the IS curve shifts to the right because of increase in net exports. Because of this, the interest rate rises. In order to bring the interest rate back down at its initial equilibrium level, the central bank increases money supply and the LM curve shifts to the right because of this. The interest rate remains the same and equilibrium AD output increases. This leads to a rightward shift of the AD curve. Since the money supply was increased, the AS curve also shifts to the right to take advantage of the lower rate of interest. The new equilibrium price level is same as the old equilibrium price level and the new equilibrium output is higher than the old equilibrium output.