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. \(L O 38.2\) 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 cause short-run inflation and reduced output; long-run adjustment restores output. Increased investment boosts short-run demand; potential long-run growth. Reduced exports decrease short-run output; long-run adjustment restores equilibrium.

Step-by-step solution

Analyze Short-Run Aggregate Supply

In the short run, the disruption in oil supply leads to increased production costs, represented by a leftward shift of the short-run aggregate supply (SRAS) curve. This shift causes the equilibrium price level to increase and the output to decrease, leading to cost-push inflation and reduced output.

Analyze Long-Run Adjustment

Over time, as wages and prices become flexible, firms adjust by finding alternative inputs or improving efficiency. Eventually, the long-run aggregate supply (LRAS) remains unchanged, but SRAS may gradually shift back to its original position as the economy returns to full employment output at a new equilibrium price level.

Short-Run Effects on Investment Spending

A dramatic rise in construction spending increases total investment spending, shifting the aggregate demand (AD) curve to the right. This increase in demand leads to higher output and an increased price level in the short run as the economy moves along the SRAS curve.

Long-Run Adjustment to Increased Investment

In the long run, as wages and input prices adjust, the economy's output returns to full employment. The increased investment may enhance productivity, potentially shifting the LRAS to the right, reflecting longer-term economic growth.

Short-Run Impact of Reduced Export Demand

A reduction in foreign demand for U.S. exports shifts the AD curve to the left, leading to a decrease in output and price levels. The initial short-run effect is a contraction in economic activity.

Long-Run Equilibrium Restoration

In the long run, the economy adjusts to reduced export demand through wage and price flexibility. Output returns to full employment levels as the SRAS shifts downward in response to lower demand, restoring equilibrium with a potentially lower price level.

Key concepts

Short-Run Aggregate Supply

In the short run, aggregate supply is sensitive to changes in production costs. Imagine you're baking a cake, and suddenly, the price of eggs triples because of a rare hen flu. In this scenario, you might bake fewer cakes. Similarly, when production costs rise due to factors like increased oil prices, the short-run aggregate supply (SRAS) curve shifts left. This leftward shift means higher prices and lower output temporarily.

Key points about SRAS:

• SRAS is what businesses can produce when current prices and wages are not fully flexible.
• It can be easily affected by sudden changes in production costs.
• Shifts in SRAS may result in inflation and fluctuations in output.

Ultimately, in the short run, businesses might struggle with cost increases, leading to higher prices and a reduced output.

Understanding these concepts helps explain how short-term disruptions affect the economy's output and price levels.

Long-Run Aggregate Supply

In the long run, the economy strives to return to a full-employment output, unaffected by short-term price fluctuations or temporary shocks. Think of it like a rubber band that snaps back to its original shape after being stretched. Over time, businesses adapt to changes by adjusting wages, finding new resource suppliers, or improving their production efficiency.

Important aspects of LRAS:

• LRAS represents the economy's potential output when all resources are fully utilized.
• In the long run, all prices, including wages, are flexible.
• Unlike SRAS, LRAS doesn't shift easily. It represents output at full employment levels.

When businesses find ways to deal with cost increases or new investments improve efficiency, the economy can continue growing. Therefore, LRAS typically remains stable unless there are significant advancements or changes in resources (like an increase in labor force or technological innovation). This adjustment reflects how the economy deals with various long-term disruptions and maintains equilibrium over time.

Aggregate Demand

Aggregate demand (AD) is the total amount of goods and services demanded across all levels of the economy at different price levels. Think of it like a shopping list for everyone in the country, where more people want more goods when prices are lower. However, several factors can cause this demand to shift.

Factors affecting AD:

• Consumer spending: More spending increases AD; a rise in savings decreases it.
• Investment spending: High construction or business investment increases AD.
• Net exports: A decrease in foreign demand for U.S. goods decreases AD.

A shift in AD could mean more output and higher prices, like during periods of increased investment. Conversely, reduced demand (like fewer exports) can lead to lower output and prices.

Understanding aggregate demand helps explain how demand-side factors can cause economic fluctuations and impact the price and output levels across an economy.

Full-Employment Output

Full-employment output represents the maximum sustainable output an economy can achieve when all resources are utilized efficiently. Imagine every worker has a job, and every machine is in use without any periods of idleness. This level of output means the economy is functioning at its best potential.

Characteristics of Full-Employment Output:

• It reflects the economy's capability without causing inflationary pressure.
• This output level marks where LRAS is positioned, regardless of price changes.
• It signifies the balance between total supply and demand that the economy can handle.

An economy operating at full employment ensures all inputs, like labor and resources, are fully and efficiently used. This point is crucial because it denotes a stable economic state where, in the absence of external shocks, the economy can sustain itself.

By understanding full-employment output, one gains insight into the natural level of efficiency and potential of a given economy.