Question

For each of the following, use an AD-AS diagram to show the short-run and long-run effects on output and inflation. Assume the economy starts in long-run equilibrium.

a. An increase in consumer confidence that leads to higher consumption spending.

b. A reduction in taxes.

c. An easing of monetary policy by the Fed (a downward shift in the policy reaction function).

d. Now, in addition to the increase in consumer spending, suppose that the economy experiences a favourable inflation shock (a sharp drop in oil price).

e. A war that raises government purchases

Answer 1

In each of the following graphs, 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)

Increase in consumer confidence increases consumption demand, increasing aggregate demand. AD curve will shift to right, increasing price level and increasing real GDP, causing an expansionary gap in short run. In the long run, higher price level raises input costs, so firms lower production, decreasing aggregate supply. SRAS shifts leftward, intersecting new AD curve at further higher price level but restoring original real GDP and eliminating expansionary gap.

In following graph, AD curve will shift rightward from AD0 to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1, with expansionary gap being equal to (Y1 - Y0) in short run. In long run, SRAS0 shifts left to SRAS1, intersecting AD1 at point C with further higher price level P2 and restoring real GDP to potential GDP level Y0, eliminating expansionary gap.

(b)

Decrease in tax increases disposable income and consumption demand, increasing aggregate demand. AD curve will shift to right, increasing price level and increasing real GDP, causing an expansionary gap in short run. In the long run, higher price level raises input costs, so firms lower production, decreasing aggregate supply. SRAS shifts leftward, intersecting new AD curve at further higher price level but restoring original real GDP and eliminating expansionary gap.

In following graph, AD curve will shift rightward from AD0 to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1, with expansionary gap being equal to (Y1 - Y0) in short run. In long run, SRAS0 shifts left to SRAS1, intersecting AD1 at point C with further higher price level P2 and restoring real GDP to potential GDP level Y0, eliminating expansionary gap.

(c)

Easier monetary policy increases money supply, lowering interest rate. A fall in interest rate increases investment, increasing aggregate demand. AD curve will shift to right, increasing price level and increasing real GDP, causing an expansionary gap in short run. In the long run, higher price level raises input costs, so firms lower production, decreasing aggregate supply. SRAS shifts leftward, intersecting new AD curve at further higher price level but restoring original real GDP and eliminating expansionary gap.

In following graph, AD curve will shift rightward from AD0 to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1, with expansionary gap being equal to (Y1 - Y0) in short run. In long run, SRAS0 shifts left to SRAS1, intersecting AD1 at point C with further higher price level P2 and restoring real GDP to potential GDP level Y0, eliminating expansionary gap.

(d)

A drop in oil price lowers input cost, which increases production, increasing aggregate supply. SRAS will shift rightward, decreasing price level and increasing real GDP in short run. In long run, wages and prices adjust, so aggregate demand will fall, further lowering price level but restoring real GDP to potential GDP.

In following graph, SRAS curve will shift rightward from SRAS0 to SRAS1, intersecting AD0 at point B with lower price level P1 and higher real GDP Y1 in short run. In long run, AD0 shifts left to AD1, intersecting SRAS1 at point C with further lower price level P2 and restoring real GDP to potential GDP level Y0.

(e)

Increase in government purchase directly increases aggregate demand. AD curve will shift to right, increasing price level and increasing real GDP, causing an expansionary gap in short run. In the long run, termination of war will lower government spending and aggregate demand, shifting AD curve leftward until it restores original equilibrium.

In following graph, AD curve will shift rightward from AD0 to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1, with expansionary gap being equal to (Y1 - Y0) in short run. In long run, AD1 shifts left to AD0, restoring long-run equilibrium at point A.