Question

1. Draw an appropriately labeled AD-SRAS-LRAS diagram illustrating a situation in which short-run output has increased, price-level has increased, and unemployment has decreased. If policymakers are wanting to return the economy back to its long-run equilibrium, what action could they take? Show the effects of this action in your diagram.

2. Suppose that a decrease in the demand for goods and services pushes the economy into recession. Assuming policymakers do nothing, what happens to the price level, output, and unemployment in the short run? What ensures that the economy still eventually gets back to the natural rate of output? What happens to price-level, output, and unemployment in the longrun? Use an appropriately labeled AD-SRAS-LRAS diagram to help explain your answer

Answer 1

1) An short run economic equilibrium which produces more than the potential level of output in the economy creates the expansionary gap in the economy. If policymakers wanted to reduce the level of output such that it reaches to its potential output, they must adopt contractionary fiscal policy through which government spending is reduced and tax is increased which reduces the disposable income and shift the aggregate demand curve to its left reducing the price level as well as level of output and take economy to its potential level.

2) As reduction in aggregate demand shifts economy into recession where less of the goods are produced than its potential level of output. If policymakers do nothing, it will reduce the price as well as output level in the economy which will raise the unemployment rate.

A expansionary fiscal policy which raises the government spending and reduce tax which will raise the disposable income and raise aggregate demand in the economy and shift demand curve from demand to new demand which will raise the price and take economy to its potential level.