Question

For each of the following events, explain the short-run and long-run effects on output and the price level, assuming policymakers take no action.

Answer the questions using sticky-wage theory.

a) The stock market declines sharply, reducing consumer’s wealth.

b) Now suppose that a stock market crash causes aggregate demand to fall. Use your diagram to show what happens to output and the price level in the short run. What happens to the unemployment rate?

c) A recessions overseas causes foreigners to buy fewer U.S. goods.

Answer 1

a) When the stock market declines sharply, wealth declines, so the aggregate-demand curve shifts to the left. In the short run, the economy moves declines from point E to point E1, as output declines and the price level declines. In the long run, the short-run aggregate-supply curve shifts to the right to restore equilibrium at point with unchanged output and a lower price level compared to the original point i.e, point E2.

**Graph is same for a and b**

b) When the stock market collapse, People loose money as a result income of people fall and aggregate demand fall. As a result short run output fall and also price fall( As SRAS1 intersect with AD2), new equilibrium is at E1.

Now the output is less than the potential output, so unemployment rate will rise above the natural unemployment rate.

Using sticky wage theory,  nominal wages are unchanged as the price level falls, firms will be forced to cut back on employment and production.Over time as expectations adjust, the short-run aggregate-supply curve will shift to the right, moving the economy back to the natural rate of output.

In the long run SRAS shift to the right to SRAS2 and the new equilibrium at E2.

c) When a recession overseas causes foreigners to buy fewer U.S. goods, net exports decline, so the aggregate-demand curve shifts to the left, as shown in the figure. In the short run, the economy moves from point A to point B, as output declines and the price level declines. In the long run, the short-run aggregate-supply curve shifts to the right to restore equilibrium at point C, with unchanged output and a lower price level compared to point A.