Question

Construct an aggregate demand and aggregate supply diagram in which the U.S. economy is initially at long run equilibrium. Suppose the European Union significantly decreases its purchases of US. exports because of trade disputes that start a trade war. (12 points) a) Show on your graph, and clearly explain in words, what would be the short-run effect on the U.S. economy. b) Show on your graph, and clearly explain in words. how the self-correcting mechanism would bring the U.S. economy back into long run equilibrium.

Answer 1

(a)

A decrease in European import demand will decrease US export demand, decreasing US net exports. This lowers US aggregate demand. In short run, AD curve will shift to left, decreasing price level and decreasing real GDP, causing a recessionary gap in short run.

In following 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 initial long-run equilibrium price level P0 and initial equilibrium real GDP (= Potential GDP) Y0. When net exports fall, AD curve will shift leftward from AD0 to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1, with recessionary gap of (Y0 - Y1) in short run.

(b)

In the long run, lower price level decreases production cost so firms increase production, raising aggregate supply. SRAS shifts rightward, intersecting new AD curve at further lower price level but restoring real GDP to potential GDP, and eliminating recessionary gap.

In above graph, SRAS0 shifts right to SRAS1, intersecting AD1 at point C with further lower price level P2 and restoring real GDP to potential GDP level Y0, eliminating recessionary gap.