Answer to Question #144793 in Accounting for Anushun Jayadharman

Question

Assume that two shocks happen simultaneously: a positive expenditure shock (buy a bigger house) and a positive supply shock (prices on imported inputs decreased dramatically due to a substantial reduction in tariffs). Use AE/PC Model without time lags (use the AE and PC graphs similarly to the textbook, place PC graph below AE graph). For your analysis, choose as a starting point (marked A) an economy operating at potential GDP (Y=Y*) and at its inflation target (

Answer 1

Positive aggregate demand shocks shift the AD curve to the right.Positive shocks to the aggregate supply move the as curve: down if it is horizontal (SRAS); to the right-down if it has a positive slope (SRAS);to the right if it is vertical (LRAS)

positive expenditure shock (buy a bigger house)  - Positive demand shocks

Suppose the economy is initially in a state of short-term and long-term equilibrium (point A), where all three curves intersect: AD, SRAS and LRAS. If aggregate demand increases, then the AD curve shifts to the right to AD2 ((a)). The growth in aggregate demand leads to the fact that entrepreneurs begin to sell off stocks and increase production, attracting additional resources, and the economy falls into point B, where the actual volume of production (Y2) exceeds the potential GDP (Y *). Point B is the point of short-term equilibrium (the intersection of the aggregate demand curve with the short-term aggregate supply curve). Attraction of additional resources (above the level of full employment) requires additional costs, therefore the costs of firms grow, and the aggregate supply decreases (the SRAS curve gradually shifts up to SRAs2), as a result of which the price level increases (from P1 to P2) and the value of aggregate demand decreases to Y *. The economy returns to the long-run aggregate supply curve (point C), but at a higher than the initial price level. Point C (like point A) is the long-term equilibrium point (the intersection of the aggregate demand curve with the long-term aggregate supply curve). Therefore, one should distinguish between equilibrium GDP and potential GDP. In our graph, equilibrium GDP corresponds to all three points: A, B, and C, but potential GDP corresponds only to points A and C when the economy is in a state of long-term equilibrium. At point B, the actual GDP is set, i.e. equilibrium GDP in the short run.

Similarly, one can consider establishing long-term and short-term equilibrium in the economy if the AS curve has a positive slope (b). The difference in the explanation lies in the fact that when justifying the transition of the economy from point A to point B, it must be borne in mind that with an increase in aggregate demand, firms not only sell stocks and increase production (which is possible for some time without increasing prices for resources ), but also raise prices for their products. Therefore, at first the economy moves along the SRAS curve, since only the price factor acts and the value of the aggregate supply grows. As a result, the economy falls into a point of short-term equilibrium - point B, which corresponds not only to a higher than in point A, the volume of output (Y2), but also a higher price level (P2). Since resource prices did not change, but the price level rose, real incomes (for example, real wages) decreased (W / P2 <W / P1). The owners of economic resources begin to demand an increase in the prices of resources (for example, nominal wages), which leads to an increase in costs (the impact of the non-price factor) and a reduction in aggregate supply (a left-upward shift of the curve

SrAS), which leads to an even greater rise in the price level (from P2 to P3). As a result, the economy falls into point C, corresponding to long-term equilibrium and potential GDP.

in the short term, they are manifested in the appearance of an inflationary output gap, when the actual GNP exceeds the potential one (Y2 > Y*), which ultimately leads to an increase in the price level, i.e., to inflation.

positive aggregate supply shock

leads to an increase in aggregate supply in the short term (the SRAS1 curve shifts to the right and down to SPAS2). The volume of output increases to Y2 in the short term, while the price level decreases to P2. But since changes in technology increase the productive capacity of the economy by increasing the productivity of resources, the aggregate supply increases over the long term (the right shift of the lras1 curve to LRAS2 — point B becomes the point of long-term equilibrium). Potential GDP increases (from Y1* to Y2*), i.e. economic growth occurs.

Thus a sharp increase in the money supply and a decrease in resource prices will lead to an even greater deviation from potential GDP in the direction of Increase