Question

Use graphical analysis to show how each of the following will 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

a. The following figure illustrates the short-run and long-run impact of the rise in oil prices on the economy.

b. The following figure illustrates the short-run and long-run impact of the rise in investment spending on the economy.

c. The following figure illustrates the short-run and long-run impact of the fall in exports on the economy.

Step-by-step solution

The short-run and long-run impact of rise in oil prices on the economy 

Oil is an essential input in most of the manufacturing units. So if oil prices rise higher due to war abroad, then the cost of production would also rise substantially. Thus cost-push inflationary situation would arise in the US economy. The short-run aggregate supply curve would shift leftward, leading to a rise in price level and a fall in GDP level in the short run. However, in the long run, in the absence of any government action, the economy will recover on its own by the rightward shift of the aggregate supply curve.

In the above figure, E_f is the long-run equilibrium point, P_f and Q_f are the initial price and GDP level, respectively. Due to the rise in oil prices, SRAS₀ shifts leftward to SRAS₁. As a result, the price level rises from P_f to P₁, and the output level decreases to Q₁ in the short run.

Since no stabilization policy is adopted in the economy, the nominal wages would fall due to the recessionary impact. So the production cost would fall, leading to a rise in the firms’ profit level. So the aggregate supply curve would revert to SRAS₀, the price level would fall to P_f, and GDP would rise to Q_f (full-employment level).

The short-run and long-run impact of rise in investment spending on the economy

The investment spending increases in the economy, which causes the aggregate demand curve to shift rightward. So the price and output level increases in the short run. The situation is referred to as demand-pull inflation. In the long run, in the absence of any government action, the economy will recover by the leftward shift of the aggregate supply curve.

The following figure illustrates the short-run and long-run impact of the rise in investment spending on the economy.

In the above figure, E_fis the long-run equilibrium point, P_f and Q_fare the initial price and GDP level, respectively. Due to the rise in investment spending, AD₀shifts rightward to AD₁. As a result, the price level rises from P_fto P₁, and the output level increases to Q1in the short run.

Due to the rise in the inflation rate, the nominal wages would rise in the long run. So the production cost would increase, leading to a decrease in the firms’ profit level. So the aggregate supply shifts leftward to SRAS₁, the price level would rise further to P₂, and GDP would fall to Q_f (full-employment level).

The short-run and long-run impact of fall in US exports 

Export is an important component of aggregate demand. So if exports fall due to foreign recession, the AD curve would shift leftward, leading to a decline in both price and output levels in the short run. So recession will occur in the US economy. However, in the long run, in the absence of any government action, the economy will recover on its own by the rightward shift of the aggregate supply curve.

The following figure illustrates the short-run and long-run impact of the fall in exports on the economy.

In the above figure, E_fis the long-run equilibrium point, P_fand Q_fare the initial price and GDP level, respectively. Now due to a decline in exports, AD₀shifts leftwards to AD₁. As a result, the price level falls from P_fto P₁,and the output level decreases to Q₁in the short run.

Due to the fall in the price level, the nominal wages also fall in the long run. So the production cost would decrease, leading to an increase in the firms’ profit level. So the aggregate supply shifts rightwards to SRAS₁, the price level further decreases to P₂, and GDP would revert to Q_f (full-employment level).