Chapter 27: Problem 11

Using aggregate demand, short-run aggregate supply, and long-run aggregate supply curves, explain the process by which each of the following economic events will move the economy from one long-run macroeconomic equilibrium to another. Illustrate with diagrams. In each case, what are 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. b. The government lowers taxes, leaving households with more disposable income, with no corresponding reduction in government purchases.

Short Answer

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Question: Explain how a decrease in households' wealth due to a decline in the stock market affects the economy in the short-run and long-run using AD, SRAS, and LRAS curves. Answer: In the short run, the decrease in households' wealth will lead to a reduction in consumer spending, causing the aggregate demand (AD) curve to shift to the left. This results in a decrease in output, an increase in unemployment, and a lower aggregate price level. In the long run, the short-run aggregate supply (SRAS) curve shifts to the right as firms reduce production costs to restore their profit margins. The economy reaches a new long-run equilibrium with an unchanged output but a lower aggregate price level.

Step by step solution

Analyze the effects on Aggregate Demand

A decrease in households' wealth will cause a reduction in consumer spending. Since consumer spending is a significant component of aggregate demand, aggregate demand will decline, shifting the AD curve to the left.

Determine the short-run impact on the economy

In the short run, the reduction in aggregate demand will cause a decrease in output and an increase in unemployment. This happens because firms produce less due to lower demand, and they cut back on employment. The SRAS curve remains unchanged, and the equilibrium moves along the curve, leading to a lower aggregate output and a lower aggregate price level.

Determine the long-run impact on the economy

In the long run, the economy will adjust to the new lower aggregate demand. The SRAS curve will shift to the right as firms reduce production costs to restore their profit margins. Eventually, the SRAS curve will intersect the new AD curve at the point where it crosses the LRAS curve, indicating that a new long-run equilibrium has been reached. In this case, the long-run aggregate output will remain unchanged, but the aggregate price level will be lower. b. The government lowers taxes, leaving households with more disposable income, with no corresponding reduction in government purchases

Analyze the effects on Aggregate Demand

Lower taxes will increase households' disposable income, leading them to consume more goods and services. This increase in consumer spending will cause an upward shift in the aggregate demand curve to the right.

Determine the short-run impact on the economy

In the short run, the increase in aggregate demand will cause a higher aggregate output level and a higher aggregate price level. The equilibrium moves along the SRAS curve since it remains unchanged. Firms will produce more to meet the increased demand and hire more workers, leading to increased employment.

Determine the long-run impact on the economy

In the long run, the economy will adjust to the new higher aggregate demand. The SRAS curve will shift to the left as firms face higher production costs due to increased demand for labor and other resources. Eventually, the SRAS curve will intersect the new AD curve at the point where it crosses the LRAS curve, indicating that a new long-run equilibrium has been reached. In this case, the long-run aggregate output will remain unchanged, but the aggregate price level will be higher.