1. Using aggregate demand, short-run aggregate supply, and long-run aggregate supply curves, explain the process and causes by which each of the following economic events will move the economy from one long-run macroeconomic equilibrium to another. In each case, explain the short-run and long-run effects on the aggregate price level and aggregate output. a. There is a decrease in households’ wealth due to a decline in the stock market.
A decrease in household wealth means lower purchasing power. The consumer reduces their consumption leading to a decline in the demand which shifts to the left from D1 to D2. As a result, in the short run both the output and aggregate price level fall as depicted by S1. A continued shift in the demand curve to the left, from D1 to D2, leads to reducing price and increasing supply which causes the supply curve to shift from S1 to S2. The long run equilibrium aggregate output and prices will remain constant. In the long run aggregate supply curve shifts to the right from S1 to S2 and the aggregate demand curve also shifts to the right from D1 to D2. The equilibrium aggregate output remains constant while the aggregate prices fall. The long equilibrium aggregate remains constant.
b. The government lowers taxes, leaving households with more disposable income, with no corresponding reduction in government purchases.
With the taxes lowered and the income still maintained, the consumers have more purchasing power. The demand for goods and services will therefore increase and shift from D1 to D2 resulting in an increase in aggregate prices and real GDP. In the long run real GDP is constant. In the short run the aggregate supply will shift to the left as aggregate demand increases and shifts to the right. In the long run aggregate prices will shift upwards while real GDP remains constant. In the long run both the demand and supply curves get new slopes. The aggregate demand curve shifts to the right while the supply curve shift to the left. Aggregate prices rise and real GDP remains constant.
2. An economy in a hypothetical country is in long-run macroeconomic equilibrium when each of the following aggregate demand shocks occurs. What kind of gap—inflationary or recessionary—will the economy face after the shock, and what type of fiscal policies, giving specific examples, would help move the economy back to potential output? a. A stock market boom increases the value of stocks held by households.
The short run aggregate supply curve shifts to the right from SRAD1 to SRAD2. Aggregate prices and real GDP increases and equilibrium shifts from E1 to E2. This will lead to inflationary gap. In the long run supply is fixed which leads to an increase in aggregate prices causing the inflationary gap. The government can control this by contractionary policies such as borrowing from the public. This inflationary gap can be solved by inflationary control such as discretionary or countercyclical fiscal policy which changes the federal government spending or taxes. b. Anticipating the possibility of war, the government increases its purchases of military equipment.
The increase in purchases of the military equipment means an increase in demand. With the increase in demand in the short run, the demand curve will shift from SRAD1 to SRAD2 with an alternative increase in price. The price level increase leads to the demand reducing in the long run from SRAD2 to SRAD3. This causes cost-pull inflation whose remedy is inflationary policies. The economy will face an inflationary gap. Policy makers could use contractionary fiscal policies to move the economy back to potential output. The government would need to reduce its purchases of nondefense good and services, increase taxes or reduce transfers. c. The quantity of money in the economy declines and interest rates increase.
As quantity of money rises in the economy and interest rates increase, the demand for goods and services declines as shown by the shift from SRAD1 to SRAD2. This happens as consumers can afford to buy more expensive items. The priority changes as customers try to save more money. In the long run, everyone has more money and demand rises again as shown by the shift in the curve from SRAD2 to SRAD3. This leads to a demand-pull inflation which can be solved by inflationary policies. The economy will face a recessionary gap. Policy makers could use expansionary fiscal policies to move the economy back to potential output.