Question

9. Applying the extended AD-AS model

Financial crises, such as the one that impacted many developed countries starting in 2007, decrease banks’ ability and willingness to make loans. Decreased availability of credit decreases businesses’ ability to make investment purchases and consumers’ ability to buy goods and services. As a result, a financial crisis is a negative shock for an economy.

The following graph shows an economy’s aggregate demand curve and its short-run and long-run aggregate supply curves after a financial crisis has pushed it into recession. Suppose that the government decides not to use a stabilization policy and allows the economy to adjust on its own.

Determine which curve, the aggregate demand curve or the short-run aggregate supply curve, shifts when the economy adjusts in the long run. Use either the blue line (circle symbol) to plot a new aggregate demand curve or the orange line (square symbol) to plot a new short-run aggregate supply curve to show the economy in long-run equilibrium. Make sure the curve you plot is parallel to one of the existing curves.

9. Applying the extended AD-AS model Financial crises, such as the one that impacted many developed countries starting in 2007, decrease banks' ability and willingness to make loans. Decreased availability of credit decreases businesses' ability to make investment purchases and consumers' ability to buy goods and services. As a result, a financial crisis is a negative shock for an economy. The following graph shows an economy's aggregate demand curve and its short-run and long-run aggregate supply curves after a financial crisis has pushed it into recession. Suppose that the government decides not to use a stabilization policy and allows the economy to adjust on its own. Determine which curve, the aggregate demand curve or the short-run aggregate supply curve, shifts when the economy adjusts in the long run. Use either the blue line (circle symbol) to plot a new aggregate demand curve or the orange line (square symbol) to plot a new short-run aggregate supply curve to show the economy in long-run equilibrium. Make sure the curve you plot is parallel to one of the existing curves. Note: You can check the slope of each line by selecting it.

Suppose many firms in this economy pay their workers efficiency wages. This practice will likely lead to a (slower/faster) adjustment of the economy to its long-run equilibrium because firms will be (more/less) likely to (raise/reduce) the wages of their employees.

Answer 1

(1) In long run, SRAS curve will shift rightward, decreasing price level (to 60) and restoring real GDP to potential GDP level (= $12 trillion).

LRAS New AD AD New SRAS PRICE LEVEL SRAS 0 2 4 16 18 20 6 8 10 12 14 REAL GDP (Trillions of dollars)

(2) Wages and resource prices fall, and SRAS shifts rightward until economy is back at long-run equilibrium.

(3) Efficiency wages will likely lead to a slower adjustment of the economy to its long-run equilibrium because firms will be less likely to reduce the wages of their employees.