Question

1. Using the ASAD graph and starting in long run equilibrium Y_A = Y* (see the model example in the textbook Figure 13.11) take each of following shocks one by one in separate graphs and decide if the event falls into the real shock (LRAS) category or aggregate demand (AD) shock category. Then graph each. Remember that “shocks” include both good and bad events and the graph should show that in the short run the economy is either that Y_A < Y* or Y_A > Y*
2. 1. Consumer Fear
   2. New inventions (A) occur at a faster pace than usual
   3. A faster money growth rate

Answer 1

In each graph, initial full-employment equilibrium is at point A where AD0 (aggregate demand), LRAS0 (long-run aggregate supply) and SRAS0 (short-run aggregate supply) curves intersect with initial equilibrium price level P0 and initial equilibrium real GDP (= potential GDP) Y0.

(1)

Consumer fear will decrease consumption demand, which decreases aggregate demand, shifting AD curve leftward and decreasing both inflation and real GDP. Unemployment increases and a recessionary gap arises in short run.

In following graph, AD0 shifts leftward to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1. Recessionary gap is (Y0 - Y1).

(2)

Fast pace of technological innovations decreases production cost, which increases aggregate supply. SRAS shifts right, decreasing inflation and increasing real GDP. Unemployment decreases in short run.

In following graph, SRAS0 shifts right to SRAS1, intersecting AD0 at point B with lower price level P1 and higher real GDP Y1.

(3)

Faster money supply growth decreases interest rate, which increases investment spending, in turn increasing aggregate demand, shifting AD curve rightward and increasing both price level and real GDP. Unemployment decreases and an inflationary gap arises in short run.

In following graph, AD0 shifts rightward to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1. Inflationary gap is (Y1- Y0).