Question

An article in the Wall Street Journal noted that real GDP in Greece declined during \(2016 .\) The article stated that economists "attributed it to a \(2.1 \%\) decline in [government spending] and weaker net exports" a. Use a basic aggregate demand and aggregate supply graph (with LRAS constant) to illustrate what happened in Greece in 2016 b. On your graph, show the adjustment back to long-run equilibrium. Source: Nektaria Stamouli, "Greek Economy Contracts at Faster Pace than Estimated Adding Hurdle to Bailout Talks," Wall Street Journal, March 6,2017

Short answer

In part (a), the aggregate demand curve shifted to the left, leading to a lower short-run equilibrium. In part (b), the economy adjusted back to the long-run equilibrium through a rightward shift of the short-run aggregate supply line.

Step-by-step solution

Drawing Initial Equilibrium

The first step is to draw the long-run aggregate supply (LRAS) line as vertical. Next, plot the aggregate demand (AD) and short-run aggregate supply (SRAS) lines intersecting at a point on the LRAS line. This intersection point represents the initial equilibrium.

Illustrating the Decrease in Aggregate Demand

The next step is to represent the impact of the decrease in government spending and weaker net exports. These factors would lead to a decrease in aggregate demand. Hence, the aggregate demand line (AD) should be shifted to the left, indicating a decrease in aggregate demand.

Marking the New Short-run Equilibrium

Due to the leftward shift in the aggregate demand line, the new intersection point between the aggregate demand and short-run aggregate supply lines also shifts to the left. We mark this new intersection point, which represents the new short-run equilibrium.

Transition to the Long-run Equilibrium

Finally, plot the transition from the short-term equilibrium back to the long-run equilibrium due to automatic mechanisms of the economy. This involves the short-run aggregate supply line (SRAS) shifting to the right until it intersects again with both the aggregate demand line (now in its new position) and the long-run aggregate supply line.

Key concepts

Long-Run Equilibrium

In economic terms, long-run equilibrium is a state where the economy is operating at its full capacity, with no upward or downward pressure on prices. This scenario occurs when the quantity of goods and services demanded equals the quantity supplied at the current price level. The long-run aggregate supply (LRAS) curve is vertical in the graph because it represents a period where all factors of production, including capital and labor, are adjusted to the economy's conditions.

This vertical positioning indicates that the economy's output is at its potential level, which isn’t affected by changes in the price level over the long-run.

• The long-run is characterized by full employment where resources are efficiently utilized.
• Shifts in the LRAS curve occur due to real changes in resource availability or technology.

Achieving long-run equilibrium ensures that the economy is stable, but reaching this state often involves short-term adjustments.

Short-Run Aggregate Supply

The short-run aggregate supply (SRAS) curve represents the relationship between the price level and the amount of goods and services firms are willing and able to produce in the short-run. In the short-run, some factors of production are fixed, usually wages and contracts, which means firms can react to price changes by adjusting their output levels rather than their input costs.

The SRAS curve is typically upward sloping, indicating that as prices increase, firms are more willing to produce more.

• Short-run aggregate supply is influenced by temporary factors such as supply shocks or changes in input prices.
• A shift in the SRAS could indicate a change in production capacity or costs, but this is often temporary.

Understanding SRAS is crucial in analyzing economic fluctuations and the time it takes to move towards long-run equilibrium.

Aggregate Demand Shift

Aggregate demand (AD) represents the total demand for goods and services in an economy at a given overall price level and in a given time period. Factors such as government spending, exports, and consumer confidence significantly affect AD. When these factors change, the aggregate demand curve shifts.

In Greece's case, a decline in government spending and weaker exports led to a leftward shift in the AD curve. This shift indicates a decrease in the total demand for goods and services in the economy.

• Leftward shifts in the AD curve generally result in reduced economic output and lower price levels.
• Rightward shifts reflect increased demand leading to higher output and prices.

Shifts in aggregate demand trigger further economic adjustments, impacting both short-run and long-run equilibrium.

Economic Adjustment Mechanisms

Economic adjustment mechanisms are the processes that help an economy return to long-run equilibrium after a disturbance. Following a shift in aggregate demand or supply, these mechanisms involve changes in wages, prices, and production that guide an economy back to its full potential output.

For Greece, the adjustment from a short-run to long-run equilibrium involved a rightward shift in the short-run aggregate supply (SRAS). As the economy adjusted, factors such as decreased wages and lower production costs led to increased output, intersecting again with both the AD and LRAS curves.

• Natural adjustments in the economy can be slow, as they rely on price and wage flexibility along with the adaptation of production capacities.
• Automatic stabilizers, like fiscal policies, can sometimes speed up the process, helping an economy recover quicker.

Understanding these mechanisms is essential for policymakers and economists who aim to maintain economic stability and growth.