Question

Suppose the people of a certain economy reduce their spending on foreign-produced goods and services. What will be the effect on real GDP and the price level in the short run? In the long run? Show your results graphically.

Answer 1

Lower spending on foreign goods (imports) will increase net exports. Higher net exports increases aggregate demand, shifting AD curve rightward, increasing both price level and real GDP in short run, causing inflationary gap.

In the long run, higher price level will raise input cost, which increases production costs. Firms will decrease production, lowering aggregate supply. SRAS shifts leftward, intersecting new AD curve at further higher price level and real GDP falls to the potential GDP. The short run inflationary gap is eliminated.

In following graph, AD0, LRAS0 and SRAS0 are initial aggregate demand, long-run aggregate supply and short-run aggregate supply curves intersecting at point A with initial price level P0 and real GDP (potential GDP) Y0. When net exports increases, AD0 shifts right to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1. Inflationary gap is (Y1 - Y0). In long run, SRAS0 shifts left to SRAS1, intersecting AD1 at point C with further higher price level P2 and restoring real GDP to potential GDP level Y0.

LRASO SRAS SRASO ADO H YO Y