Question

Use an aggregate demand and aggregate supply graph to illustrate the situation where equilibrium initially occurs with real GDP equal to potential GDP and then the aggregate demand curve shifts to the left. What actions can Congress and the president take to move real GDP back to potential GDP? Show the results of these actions on your graph. Assume that the long-run aggregate supply (LRAS) curve doesn't shift.

Short answer

Initially, equilibrium GDP is equal to potential GDP at the intersection of the SRAS and AD curves. When AD shifts left, the output decreases below the potential, and a gap is created resulting in economic contraction. To rectify this, Congress and the President can utilize expansionary fiscal policies such as reducing taxes or increasing government spending to stimulate demand. This simulation would shift the AD curve back to the right, narrowing and potentially eliminating the gap, returning output to the potential GDP.

Step-by-step solution

Drawing the Initial Graph

The initial aggregate demand and supply graph is drawn with the X-axis as Real GDP and the Y-axis as Price level. The aggregate supply curve (SRAS), Aggregate demand curve (AD) and the Long-Run Aggregate Supply curve (LRAS) are plotted. Equilibrium is indicated at the intersection of SRAS and AD, signifying initial GDP in equilibrium with potential GDP.

Illustrating the shift in Aggregate Demand

After the initial setup, the aggregate demand curve (AD) shifts to the left. This is where real GDP drops below the potential output and create a gap, causing an economic contraction.

Intervention by Congress and the President

Congress and the president can implement expansionary fiscal policy measures to boost economic activity and close the gap, such as decreasing taxes or raising government spending to stimulate aggregate demand.

Demonstrate the results graphically

The results are shown by shifting the aggregate demand curve (AD) back to the right towards the SRAS curve. This suggests that the economy begins to expand as aggregate demand is stimulated, pushing the nation's output back towards potential GDP, assuming the LRAS curve does not shift.

Key concepts

Economic Contraction

When we talk about an economic contraction, what comes to mind is a phase where a nation's economy begins to decline. This can often be visualized as the decreasing aggregate demand reflected in a leftward shift on an aggregate demand and supply graph. During economic contraction, businesses may witness a drop in sales, high unemployment rates may occur, and overall economic output dips below the standard level.

It is critical at this point to understand that a nation's real GDP, which represents the total value of goods and services made within a country, falls short of what we call 'potential GDP'. Potential GDP is the maximum possible level of output an economy can sustain over a period without causing inflation. Factors like reduced consumer spending, cuts in business investment, or an unfavorable external trade environment can trigger contractions. Such movements have significant implications - for individuals, it might mean job losses or decreased income; for businesses, reduced profits and potential downsizing; and for the government, lower tax revenues and higher demands for welfare services.

Expansionary Fiscal Policy

To combat an economic contraction, governments can employ expansionary fiscal policy. This involves strategic changes in government spending and taxation designed to stimulate economic growth. When the aggregate demand curve shifts to the left, indicating a downturn, expansionary tactics can realign output with its potential.

How It Works

One key method includes increasing government spending, which directly pumps money into the economy through government projects and services. Another method is reducing taxes to leave more disposable income with businesses and consumers, boosting their spending power.

Ultimately, the goal of expansionary fiscal policy is to increase aggregate demand. When done effectively, it can lead to increased production, job creation, and a rise in consumer confidence. Policymakers must strike a balance though - excessive stimulus can risk inflation if the economy reaches beyond its potential GDP.

Long-Run Aggregate Supply (LRAS)

The long-run aggregate supply (LRAS) curve is a critical part of understanding an economy's capacity. In the long term, an economy’s production of goods and services (its real GDP) is determined by available resources – like labor, capital, and technology – rather than by the current price level.

Price Level Irrelevance

In the long run, prices of inputs and outputs can adjust fully to changes in the economy. This means that the LRAS curve is vertical, representing an economy’s potential GDP. It assumes all resources are efficiently utilized and any unemployment is largely frictional or structural, not due to fluctuations in demand.

The LRAS does not shift due to short-term economic fluctuations. Instead, it changes with improvements in technology, increases in labor supply, and other factors that enhance production capacity, thus shifting the LRAS curve to the right, indicating potential economic growth.

Potential GDP

The concept of potential GDP refers to the maximum output an economy can sustain over a long period without triggering inflation. Think of it as the 'full health' level of productivity of an economy, where all resources are employed efficiently.

Determining Factors

Several factors play a role in determining potential GDP such as technology, the size and skills of the labor force, and the stock of capital - including infrastructure, machinery, and equipment. It serves as an important benchmark for policymakers, indicating whether the economy is underperforming or overheating.

When real GDP falls below potential GDP, it hints at unused resources and capacity, which can lead to extended periods of unemployment and lower standards of living. Conversely, if the economy operates above its potential GDP, it may encounter inflationary pressures. Therefore, the ideal economic objective is to operate at the level of potential GDP, ensuring stable prices and full employment.