Use an aggregate demand and aggregate supply graph to illustrate the situation where equilibrium initially occurs with real GDP equal to potential GDP and then the aggregate demand curve shifts to the left. What actions can Congress and the president take to move real GDP back to potential GDP? Show the results of these actions on your graph. Assume that the long-run aggregate supply (LRAS) curve doesn't shift.

When we talk about an economic contraction, what comes to mind is a phase where a nation's economy begins to decline. This can often be visualized as the decreasing aggregate demand reflected in a leftward shift on an aggregate demand and supply graph. During economic contraction, businesses may witness a drop in sales, high unemployment rates may occur, and overall economic output dips below the standard level.

It is critical at this point to understand that a nation's real GDP, which represents the total value of goods and services made within a country, falls short of what we call 'potential GDP'. Potential GDP is the maximum possible level of output an economy can sustain over a period without causing inflation. Factors like reduced consumer spending, cuts in business investment, or an unfavorable external trade environment can trigger contractions. Such movements have significant implications - for individuals, it might mean job losses or decreased income; for businesses, reduced profits and potential downsizing; and for the government, lower tax revenues and higher demands for welfare services.

To combat an economic contraction, governments can employ expansionary fiscal policy. This involves strategic changes in government spending and taxation designed to stimulate economic growth. When the aggregate demand curve shifts to the left, indicating a downturn, expansionary tactics can realign output with its potential.

How It Works

One key method includes increasing government spending, which directly pumps money into the economy through government projects and services. Another method is reducing taxes to leave more disposable income with businesses and consumers, boosting their spending power.

Ultimately, the goal of expansionary fiscal policy is to increase aggregate demand. When done effectively, it can lead to increased production, job creation, and a rise in consumer confidence. Policymakers must strike a balance though - excessive stimulus can risk inflation if the economy reaches beyond its potential GDP.

The long-run aggregate supply (LRAS) curve is a critical part of understanding an economy's capacity. In the long term, an economy’s production of goods and services (its real GDP) is determined by available resources – like labor, capital, and technology – rather than by the current price level.

Price Level Irrelevance

In the long run, prices of inputs and outputs can adjust fully to changes in the economy. This means that the LRAS curve is vertical, representing an economy’s potential GDP. It assumes all resources are efficiently utilized and any unemployment is largely frictional or structural, not due to fluctuations in demand.

The LRAS does not shift due to short-term economic fluctuations. Instead, it changes with improvements in technology, increases in labor supply, and other factors that enhance production capacity, thus shifting the LRAS curve to the right, indicating potential economic growth.

The concept of potential GDP refers to the maximum output an economy can sustain over a long period without triggering inflation. Think of it as the 'full health' level of productivity of an economy, where all resources are employed efficiently.

Determining Factors

Several factors play a role in determining potential GDP such as technology, the size and skills of the labor force, and the stock of capital - including infrastructure, machinery, and equipment. It serves as an important benchmark for policymakers, indicating whether the economy is underperforming or overheating.

When real GDP falls below potential GDP, it hints at unused resources and capacity, which can lead to extended periods of unemployment and lower standards of living. Conversely, if the economy operates above its potential GDP, it may encounter inflationary pressures. Therefore, the ideal economic objective is to operate at the level of potential GDP, ensuring stable prices and full employment.