Question

what is the difference between the short run and the long run equilibrium in the AD-AS 6. The economy is in a deep recession. In order to close the output gap, the government is planning on sending a cheque (money) to all households. Explain the short-run and the long run impact of this intervention using the ADAS model. 7. Explain in plain words how the impact of the fiscal policy described above depends on the slope of the AS curve. 8. Describe the adjustment process in the AD-AS model. AD

Answer 1

6.

To come out from the recession, the government has increased spending in the form of sending money to all households. In the short run, it will increase the consumption and stimulate the aggregate demand. It will increase the real output and price level at the new equilibrium in the short run. in the context of long run, the economy achieves the output that is equal to potential output level in the economy. Further, the unemployment level also reaches to the level of natural rate of unemployment. Though, there is an increased price level in the economy. It is shown in the following diagram.

LRAS SRAS Pricel P1 £1 E P AD1 AD Q Q'. Real GDP

In the above diagram, potential output Q' is achieved in the long run at P1 price level and it is shown by E1 equilibrium level.

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7

Impact of fiscal policy depends upon the slope of AS in a way that slope can make AS curve to be more elastic or less elastic in nature. If AS curve is more steep, then it means that AS curve is relatively inelastic in nature. It means impact of fiscal policy will be less or slow and take more time.

When AS curve is more flatter in nature then it makes AS curve to be more elastic in nature. As a result, fiscal policy can make stronger impact and achieve objective in shorter time.

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8.

When expansionary policy is implemented, then it increases the consumption and AD increases. It causes Ad curve to shift to the right. As a result, a new equilibrium is created with increased price level and real output . The reverse happens when contractionary fiscal policy is implemented in the AS-AD model.