Question

Please help me with this question. Thank you!

Suppose the US increased tariffs on imports from 2% to 20%. To retaliate, other countries increased their tariffs too.

1. Represent this in an aggregate supply and demand diagram? Which curve shifts and direction?

2. What's the new short-run equilibrium and Long-run equilibrium? What happens to inflation and output in the US?

Answer 1

(1)

When other countries increase tariff against US-made goods, US export demand falls, which decreases net exports and decreases aggregate demand. The AD curve will shift leftward.

In following graph, initial long-run equilibrium is at point A where AD0 (aggregate demand), LRAS0 (long-run aggregate supply) and SRAS0 (short-run aggregate supply) curves intersect, with long-run equilibrium price level P0 and real GDP (= Potential GDP) Y0. When aggregate demand falls, AD0 will shift leftward to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1, with recessionary gap of (Y1 - Y0) in short run.

LRASo SRAS 0 5RAS, 0 ADo 2 ADI I Yo

(2) In short run, a leftward shift in AD curve will decrease both price level (inflation) and real GDP (output). In the long run, lower price level will reduce production cost, so firms will increase production, increasing aggregate supply. SRAS curve will shifts rightward, further decreasing price level (inflation), but restoring real GDP to potential GDP. So,

In short run - Inflation decreases, output decreases

In long run - Inflation decreases, output remains unchanged (with respect to initial output level).

In above graph, SRAS0 shifts right to SRAS1, intersecting AD1 at point C with further lower price level P2 and restoring real GDP to potential GDP level Y0, eliminating recessionary gap.