Question

Use shifts of the AD and AS curves to explain (a) the U.S. experience of strong economic growth, full employment, and price stability in the late 1990s and early 2000s and (b) how a strong negative wealth effect from, say, a precipitous drop in house prices could cause a recession even though productivity is surging.

Short answer

a. The change in AD and AS curve is of the same magnitude; that is shown below:

b. The AD curve falls, and there is a rise in AS curve, which is shown below:

Step-by-step solution

Explanation of part (a)

The U.S. experienced strong economic growth, full employment, and price stability in the late 1990s and early 2000s, i.e., both AD and AS curve rises in the same magnitude.

The aggregate demand curve shifts from AD₁ to AD₂, and the aggregate supply curve shifts from AS₁ to AS₂ as productivity increases and the labor force grows. Hence, the output level rises, but the price level remains constant. The magnitude in change is the same for both AD and AS curves; thus, the equilibrium shifts rightward.

Explanation of part (b)

A steep drop in house prices could cause a recession even though productivity surges; thus, the AD curve shifts left, and the AS curve shifts to the right due to productivity increase.

The AD curve shift left or fall from AD₁ to AD₂ because of a steep drop in house prices, but the AS curve shifts rightward from AS₁ to AS₂ because productivity increases. The price falls from P₁ to P₂, and the quantity falls from Q₁ to Q₂. Hence, it is a recessionary situation.