Question

Using aggregate demand, short-run aggregate supply, and long-run aggregate supply curves, explain the process by which each of the following economic events will move the economy from one long-run macroeconomic equilibrium to another. Illustrate with diagrams. In each case, what are the short-run and long-run effects on the aggregate price level and aggregate output? a. There is a decrease in households' wealth due to a decline in the stock market. b. The government lowers taxes, leaving households with more disposable income, with no corresponding reduction in government purchases.

Short answer

Question: Explain how a decrease in households' wealth due to a decline in the stock market affects the economy in the short-run and long-run using AD, SRAS, and LRAS curves. Answer: In the short run, the decrease in households' wealth will lead to a reduction in consumer spending, causing the aggregate demand (AD) curve to shift to the left. This results in a decrease in output, an increase in unemployment, and a lower aggregate price level. In the long run, the short-run aggregate supply (SRAS) curve shifts to the right as firms reduce production costs to restore their profit margins. The economy reaches a new long-run equilibrium with an unchanged output but a lower aggregate price level.

Step-by-step solution

Analyze the effects on Aggregate Demand

A decrease in households' wealth will cause a reduction in consumer spending. Since consumer spending is a significant component of aggregate demand, aggregate demand will decline, shifting the AD curve to the left.

Determine the short-run impact on the economy

In the short run, the reduction in aggregate demand will cause a decrease in output and an increase in unemployment. This happens because firms produce less due to lower demand, and they cut back on employment. The SRAS curve remains unchanged, and the equilibrium moves along the curve, leading to a lower aggregate output and a lower aggregate price level.

Determine the long-run impact on the economy

In the long run, the economy will adjust to the new lower aggregate demand. The SRAS curve will shift to the right as firms reduce production costs to restore their profit margins. Eventually, the SRAS curve will intersect the new AD curve at the point where it crosses the LRAS curve, indicating that a new long-run equilibrium has been reached. In this case, the long-run aggregate output will remain unchanged, but the aggregate price level will be lower. b. The government lowers taxes, leaving households with more disposable income, with no corresponding reduction in government purchases

Analyze the effects on Aggregate Demand

Lower taxes will increase households' disposable income, leading them to consume more goods and services. This increase in consumer spending will cause an upward shift in the aggregate demand curve to the right.

Determine the short-run impact on the economy

In the short run, the increase in aggregate demand will cause a higher aggregate output level and a higher aggregate price level. The equilibrium moves along the SRAS curve since it remains unchanged. Firms will produce more to meet the increased demand and hire more workers, leading to increased employment.

Determine the long-run impact on the economy

In the long run, the economy will adjust to the new higher aggregate demand. The SRAS curve will shift to the left as firms face higher production costs due to increased demand for labor and other resources. Eventually, the SRAS curve will intersect the new AD curve at the point where it crosses the LRAS curve, indicating that a new long-run equilibrium has been reached. In this case, the long-run aggregate output will remain unchanged, but the aggregate price level will be higher.

Key concepts

Short-run Aggregate Supply

The short-run aggregate supply (SRAS) curve demonstrates how the total output of goods and services in an economy responds to changes in the price level. In the short run, many production costs are fixed, so producers may ramp up supply without a corresponding immediate increase in wages or resource costs.
This means that in response to an increased demand (such as from reduced taxes and more consumer spending), firms can increase production. But, if aggregate demand drops, firms usually don't decrease production immediately, because fixed costs remain constant.
The position of the SRAS curve is influenced by factors such as:

• Changes in input costs: A fall in input costs can shift the SRAS to the right, increasing supply at every price level.
• Temporary supply shocks: Events like natural disasters can temporarily decrease supply, shifting the SRAS to the left.

The short-run equilibrium is where the aggregate demand curve intersects the SRAS curve, determining the output and price level in the economy.

Long-run Aggregate Supply

The long-run aggregate supply (LRAS) curve is vertical, reflecting the economy’s full employment level of output in the long run. This curve does not change with the price level, as it represents a time when all resources, including labor and capital, are fully flexible.
Over time, as input prices adjust, the economy naturally gravitates towards this full employment level. During this period, factors such as technology improvements and an increase in the labor force can shift the LRAS curve to the right, indicating economic growth.
Key determinants of the LRAS include:

• Technological advancements: Innovations can make production more efficient, increasing potential output.
• Resource availability: Increases in available resources such as labor and capital can boost potential output.

This inherent adjustment means that despite short-term fluctuations, the economy aims to stabilize at its potential output in the long run.

Macroeconomic Equilibrium

Macroeconomic equilibrium occurs when the aggregate demand (AD), short-run aggregate supply (SRAS), and long-run aggregate supply (LRAS) all intersect. This intersection represents the point where the quantity of goods and services demanded equals the quantity supplied at the price level.
In the short term, economic shocks might move the economy from this equilibrium. For example, a decrease in wealth could shift AD to the left, leading to lower output and price levels initially. Conversely, increased consumer spending from lower taxes might shift AD to the right, raising both output and prices in the short run.
Over the long run, however, the economy tends to return to equilibrium at full employment output. Transitions between these states depend on various policy responses and inherent economic adjustments, such as wage flexibility and shifts in production costs. Ultimately, achieving macroeconomic equilibrium requires aligning short-run dynamics with long-run potentials through proactive economic policies and adaptive market systems.