Question

AS/AD: Assume the economy is currently at potential output. Then, a major increase in stock prices makes consumers feel wealthier, leading them to increase their consumption spending.

a) What does it mean for the economy to be at “potential output”? What determines the potential output?

b) Use the Aggregate Supply and Demand model to analyze the short-run impact that this new policy will have on real GDP and the price level. This is the “Shock.”

c) Assuming no other changes in policy, describe how this policy will affect real GDP and inflation in the long-run. Start with your answer to part b), and describe how the economy moves to its new long-run equilibrium. Response, New Equilibrium.

Answer 1

a) Potential output is the level of output where the nation is producing at the maximum level, beyond this level if the nation produces it will be facing an inflation, at the potential level, the inflation will be zero, unemployment level will be at the natural rate.Potential output is determined by capital, technology, and labor supply i.e. population.

b) An increase in the stock and income level will shift the aggregate demand curve to the right and the new equilibrium in the market will be at a higher price level and higher output. THe GDP and the price will be higher.

c) In the long run, as the real wages here has declined the employer will demand an increase in the wages, an increased wages will act as a negative supply shock and that will shift the supply curve to the left, the long run equilibrium will be at a lower output and higher price.