Question

1. Using the AS-AD model diagram, illustrate what happens to the LONG-RUN and SHORT-RUN equilibrium level of aggregate output and inflation, when the economy is hit by a negative (adverse) demand shock and there is NO POLICY response. Suppose the economy is at a long-run equilibrium before it is hit by the negative demand shock. Make sure you properly label all the axes and curves. Will the negative demand shock more likely lead to an expansion or recession in the short-run?

2. Consider the situation above, i.e. the economy has been hit by a negative demand shock and as a result the economy is currently at a short-run equilibrium. What can the Federal Reserve (monetary policy) do to mitigate (or even reverse) the consequences of the negative demand shock? In other words, using the AS-AD model diagram illustrate how the action of the Federal Reserve impacts the economy in the long-run (after the negative demand shock) in terms of inflation and output – which curve(s) in the AS-AD framework shifts and why?

Answer 1

1) In the image on the left, the economy is in the long run equilibrium where the output is full employment output. Due to an adverse demand shock, the Aggregate Demand curve shifts to the left as shown in the image on the right. This leads to lower output in the short run with lower prices. Hence, the leftward shift of Aggregate Demand curve leads to a recessionary gap in the economy in the short run, The following image shows what would happen in the long run.

In the short run, since the prices fall, wages would fall and so would the prices of the resources required for production. Hence, in the long run Aggregate Supply curve would shift to the right as it would now be cheaper to produce output. This would bring the output back at full employment output and the price level in this long run equilibrium would be lower than the price level in the previous long run equilibrium. This isknown as the self correcting mechanism of the economy.

2) The self correcting mechanism usually takes a long time to come into effect as in the short run wages are sticky and they take a long time to adjust to a lower price level. Therefore, the government can speed up the process of recovery by implementing an appropriate monetary/fiscal policy. In this case, since the economy is in a short run recessionary gap, the government can increase money supply which would decrease the interest rate. At a lower interestratethe investors would make larger investments and hence, the Aggregate Demand curve would shift to the right till the output is back at full employment output. In the long run, the price level returns to the price level in the long run equilibrium before the demand shock.