Question

Using aggregate demand, SRAS and LRAS, and assuming the economy is initially at long run equilibrium, explain the process by which each of the following economic events will move the economy from one long-run macroeconomic equilibrium to another with the aid of a well labeled diagram

(a) A major trading partner experienced economic growth

(b) Investors become optimistic about the economy

(c) There is a decrease in taxes

Answer 1

a)

LRAS SRAS Price level AD AD Y Y' output

if a major trading partner experienced economic growth so it will leads to increase in our exports they increase there imports.When exports in our economy increases, More people are employed, more raw material is purchased and more investment is done to meet rise in demand. Thus Income and employment in our economy increase consequently Aggregate demand in our economy increases and demand curve shift rightward from AD to AD' which cause increase in price level from P to P' and output increases from Y to Y'.

b) if investor become optimistic about the economy they invest more in the economy which leads to increase in investment.In the long term, an increase in investment should also increase productive capacity and increase aggregate supply.

Therefore, investment can enable a more sustainable increase in AD. The increase in capacity enables a sustained rise in AD without causing inflation. If the economy is at full capacity and AD rises then there will be just inflation.Effective investment can help increase the long-run trend rate of economic growth.

LRAS LRAS' Price level AD' SAD output / Real GDP

c)Cutting taxes when the economy is already growing quickly is likely to cause inflationary pressures.Lower income tax rates increase the spending power of consumers and can increase aggregate demand, leading to higher economic growth. decrease in taxes lead to rightward shift in aggregate demand curve from AD to AD' and increase in real GDP from Y to Y' and increase in price level from P to P'.

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