Question

QUESTION 7 (25 points): Economic Fluctuation using AD-AS framework Suppose that the short-run aggregate supply curve has a positive slope and that the economy starts at a long-run equilibrium. Now imagine that 10 million people move to Australia they found that Australians live an average of 10 extra years due to the relax lifestyle that they enjoy. This is a permanent change in Labor in the U.S. economy. (a) (10 points) No Policy Intervention: Using the model of Aggregate Demand and Aggregate Supply developed in class, illustrate graphically the impact in the U.S. of this movement of people to Australia in the short run and the long run. Be sure to label the axes, the curves, the initial equilibrium values, the direction the curves shift, the short run equilibrium values, and the long run equilibrium values. Explain what happens to prices and output in the U.S. economy, both in the short run and the long run.

Answer 1

Given: The economy is at the long run equilibrium level Situation: 10 million people have moved from the U.S. to Australia. This change has brought a permanent change in Labor supply in the U.S. economy. Case 1: No Policy Intervention (a) In the case of migration (population decrease), the aggregate supply curve will shift to the left price LRAS AS AS P" Р AD Y' Y output The economy is in the long run equilibrium level (point E). The initial equilibrium is the point where the AD and the AS curve intersects the LRAS curve. The initial equilibrium price is P and the initial equilibrium quantity is Q. The event of the migration from the U.S. to Australia will decrease the aggregate supply. The aggregate supply curve will shift leftwards from AS to AS' due to the negative supply shock. The decrease in the aggregate supply will create an upward pressure on the price and the price will increase fromP to P' and the output will fall from Y to Y'. In the long run, the economy will operate on the long run supply curve (LRAS) which is at point B. However, the price will increase to P" but the output will return to the equilibrium level of Y

(b) With policy intervention: In the case of policy intervention, the government will intervene using its fiscal policy tool. The event of a decrease in population which has resulted from migration will affect the aggregate supply curve. The aggregate supply curve will shift leftwards from AS to AS' With government intervention, the government will intervene and influence the aggregate spending of the economy by boosting the aggregate demand. The aggregate demand will shift rightwards from AD to AD' The economy is in the long run equilibrium level (point E). The initial equilibrium is the point where the AD and the AS curve intersects the LRAS curve. The initial equilibrium price is P and the initial equilibrium quantity is Q price LRAS AS' AS P KE AD* AD Y output The new aggregate supply curve which is AS' and the new aggregate demand curve which is AD' will intersect the LRAS at point A. The new equilibrium price increases from P to P" and the equilibrium output remains same at Y (c) The value of output that anchors the LRAS curve is called the Natural Rate of Output because it is the potential output which is not affected by the changes made in the price level and other nominal variables. It is the potential output which an economy can produce after using all the factors of production efficiently