Question

a) In 2008, inflation was unusually high (meaning prices increased more than usual), GDP growth fell, and unemployment increased. Use the aggregate supply and demand model to suggest what might have happened at the beginning of the great recession.

b) In 2009, the US experienced deflation (meaning prices were falling), and GDP actually decreased. Unemployment increased to 10%. Use the aggregate supply and demand model to suggest what might have happened during the second half of the great recession.

c)Assume the economy is in equilibrium. Explain exactly, i.e., one step at a time, why the price level and real GDP will change if the price of oil (a major input in many businesses) increases. Describe the process from the beginning to where the economy reaches a new equilibrium.

d)An economy is currently producing at an equilibrium level of real GDP of $14 trillion. What will happen if government spending (alone, with no other changes) decreases by $100 billion? Will real GDP increase or decrease? Explain why it will change by $100 billion, by less, or by more.

e)Explain why rising prices reduce the spending multiplier effect of an increase in aggregate demand.

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.

(a)

When aggregate supply falls, the SRAS curve shifts leftward, leading to higher price level (inflation) and lower GDP, causing high unemployment. This is known as stagflation. In following graph, SRAS0 shifted leftward to SRAS1, intersecting AD0 at point B with higher price level P1 and lower real GDP Y1.

(b)

When aggregate demand falls, the AD curve shifts leftward, leading to lower price level (deflation) and lower GDP, causing high unemployment. This creates a recessionary gap. In following graph, AD0 shifted leftward to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1.

NOTE: As per Answering Policy, 1st 2 questions are answered.