Question

Suppose that the economy is at long-run equilibrium. a. Draw a diagram to illustrate the state of the economy. Be sure to show aggregate demand, short-run aggregate supply, and long-run aggregate supply. b. Now suppose that a severe decline in the value of homes has affected the entire economy. Use your diagram to show what happens to output, employment, and the price level in the short run. Explain how households and businesses will adjust to this unanticipated shock to the economy. What will happen to output, employment, and the price level in the long-run? Be sure to illustrate this change on your graph

Answer 1

(a)

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 long-run equilibrium real GDP (which is equal to potential GDP) Y0.

LRASO SRAS. SRAS, Y Yo

(b)

Decline in value of home will decrease consumer wealth, so they will reduce consumption. A decrease in consumption will decrease aggregate demand. AD curve will shift to left, reducing both price level and real GDP, giving rise to a recessionary gap in short run. Lower real GDP will increase unemployment rate.

In above graph, when aggregate demand falls, AD curve will shift leftward from AD0 to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real output Y1, with short run recessionary gap of (Y0 - Y1).

(c)

In the long run, lower price level will reduce wages and prices of inputs, lowering production costs. Firms will increase output, increasing aggregate supply. SRAS shifts rightward, intersecting new AD curve at further lower price level but restoring real GDP to potential GDP level, wiping out the short-run recessionary gap. Unemployment rate will restore at natural (full-employment) rate.

In above graph, in long run, 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, removing the short-run recessionary gap.