Question

Use graphical analysis to show how each of the following would affect the economy first in the short run and then in the long run. Assume that the United States is initially operating at its full-employment level of output, that prices and wages are eventually flexible both upward and downward, and that there is no counteracting fiscal or monetary policy. a. Because of a war abroad, the oil supply to the United States is disrupted, sending oil prices rocketing upward. b. Construction spending on new homes rises dramatically, greatly increasing total U.S. investment spending. c. Economic recession occurs abroad, significantly reducing foreign purchases of U.S. exports.

Short answer

Oil disruptions and export reductions cause short-run output decreases; long-run adjustments restore full employment. Increased construction boosts short-run output, leading to longer-term price and wage changes.

Step-by-step solution

Analyze the Short-Run Effects of Oil Supply Disruption

When the oil supply is disrupted due to war, oil prices rise, causing production costs to increase across various sectors of the economy. In the short run, this leads to a leftward shift of the Aggregate Supply (AS) curve, from its initial position to AS1. This results in a higher price level and lower output, moving the economy to a short-run equilibrium below full employment.

Examine Long-Run Adjustment of Oil Supply Disruption

In the long run, flexible prices and wages allow the economy to adjust back to full employment. The high production costs normalize as the Aggregate Supply shifts back rightward to its original position. This restores the economy to its full-employment output level, though potentially at a higher general price level if inflationary pressures persist.

Consider Short-Run Implications of Increased Construction Spending

A dramatic rise in construction spending increases Aggregate Demand (AD). The AD curve shifts rightward from AD0 to AD1 due to heightened investment spending. In the short run, this boosts economic output and raises the price level, resulting in economic expansion beyond the full-employment output.

Long-Run Adjustment of Increased Construction Spending

In the long run, increased demand can lead to price and wage adjustments as the economy tries to restore equilibrium. The Aggregate Supply curve may shift leftward as firms face higher costs, eventually returning the economy to its full-employment output with a potentially higher price level than initially.

Short-Run Impact of Reduced Export Demand

When an economic recession abroad reduces demand for U.S. exports, the Aggregate Demand curve shifts leftward from AD0 to AD1. This causes a decline in the overall economic output and lowers the price level in the short run, pushing the economy into a recessionary gap.

Long-Run Response to Reduced Export Demand

In the long run, the economy adjusts through wage and price flexibility. The Aggregate Supply curve may shift back to its original level as firms lower production costs, and thus, restoring the economy to full-employment output and equilibrium price levels.

Key concepts

Understanding Aggregate Supply and Demand

Aggregate Supply (AS) and Aggregate Demand (AD) are foundational concepts in economics, crucial for understanding economic fluctuations. Aggregate Demand refers to the total demand for goods and services within an economy, combining consumption, investment, government spending, and net exports. Aggregate Supply, on the other hand, describes the total output or production that firms are willing and able to make at different price levels.

In graphical analysis, the intersection of the AS and AD curves reflects the economic equilibrium, indicating both the price level and the total output of an economy. When one curve shifts, it reflects changes, either temporary or permanent, in the economy's conditions.

• Shifts in the AD curve can result from changes in consumer preferences, government policy, or international economic conditions.
• The AS curve shifts due to changes in production costs, resource availability, and technologies.

This interaction helps us visualize and think through how various factors can impact the economy both immediately and over time.

Short-Run and Long-Run Adjustments

In economics, it’s important to differentiate between short-run and long-run adjustments to various economic changes. The short run is a period in which not all resources or prices can fully adjust. Generally, this means that some elements of production (like wages or prices) are sticky or slow to change, leading to some immediate effects on output and employment levels.

For example, in the short run, a spike in oil prices due to external disruptions could lead to increased production costs, shifting the AS curve leftward. Such a change in the AS curve would increase prices and reduce output, potentially leading the economy into a phase below full employment.

In contrast, the long run is characterized by full flexibility in prices and wages. Over time, firms and workers adjust to new economic realities, and market forces work to bring the economy back to full-employment output. During these adjustments, the AS curve can move back to its original position, reflecting restored economic balance even if overall price levels have permanently changed.

• Short-run focuses on immediate responses and stickiness in prices.
• Long-run focuses on eventual equilibrium as prices and wages adjust.

The Full-Employment Level

Full employment is a key economic benchmark indicating when all available resources in the economy are used efficiently. At the full-employment level, the labor market is balanced, meaning there is no cyclical unemployment. However, it doesn’t mean zero unemployment; there is still frictional and structural unemployment due to normal labor market turnover and transitions.

In an economy initially at full employment, any shift in either the Aggregate Demand or Aggregate Supply curves would cause temporary imbalances. In the case of increased construction spending, for example, the economy might temporarily operate above full employment, where the AD curve shifts rightward, pushing beyond the full-employment output in the short run. This expansion may result in upward pressure on wages and resource prices until the economy catches up again in the long run.

• Full employment is an ideal state, balancing production without excessive inflation or deflation.
• It’s a benchmark for evaluating the nature of shifts in AS and AD.

Exploring Price Elasticity

Price elasticity in economics helps measure how much the quantity demanded or supplied of a good changes when the price changes. Specifically, it reflects responsiveness. High elasticity implies significant changes in quantity demanded when prices change, whereas low elasticity suggests only minor changes regardless of price shifts.

Understanding price elasticity is essential when examining disturbances like oil price spikes. If oil demand is inelastic, consumers continue to buy even as prices rise, leading to higher overall production costs across the economy. Conversely, if demand is elastic, significant changes in consumption patterns occur, and adjustments in aggregate supply may happen more swiftly.

• Elasticity affects how quickly the market can adjust to new price levels.
• Inelastic goods often create enduring economic pressures when prices fluctuate.

Navigating Economic Recession Effects

Economic recessions pose significant challenges as they often lead to declines in aggregate demand, output, and employment levels. Such downturns can result from various factors, including reduced foreign consumption of exports during a global recession.

In the short run, decreased international demand for exports would shift the AD curve leftward, resulting in lower production levels and falling price levels. The economy then experiences a recessionary gap, where output is below the full-employment level.

Over time, long-run adjustments would include lowering costs and improving competitiveness. The market naturally adjusts as wages and prices become more flexible. This process eventually shifts the AS curve to its original state, rebalancing the economy at a new equilibrium that reflects its restored efficiency.

• Recessionary effects reduce total demand, impacting employment and growth.
• Long-run adjustments help realign economy closer to full employment.