Question

Suppose Mexico, one of our largest trading partners and purchaser of a large quantity of our exports, goes into a recession. Use the AD/AS model to determine the likely impact on our equilibrium GDP and price level.

Short answer

In conclusion, a recession in Mexico, a significant trading partner, would likely lead to a decrease in our aggregate demand due to reduced demand for our exports. Using the AD/AS model, we can determine that this would result in a new equilibrium with a lower GDP and a lower overall price level in our economy, indicating a slowdown in economic growth and possible deflationary pressures. This could lead to various negative impacts on individual firms and households, such as reduced investments, decreased consumption, and increased unemployment.

Step-by-step solution

Understand the AD/AS Model

The Aggregate Demand/Aggregate Supply (AD/AS) model is an economic model that explains the interaction between aggregate demand (the quantity of goods and services that households, firms, and the government want to buy at all possible price levels) and aggregate supply (the total quantity of goods and services that firms are willing to produce at all possible price levels) in an economy. The model helps us analyze the effects of different economic events on the overall economy, including the equilibrium GDP and price level.

Analyze the impact of Mexico's recession on our aggregate demand

As Mexico is a significant trading partner and a significant purchaser of our exports, a recession in their economy would likely lead to a decrease in their aggregate demand for goods and services. Consequently, the demand for our exports to Mexico would also decline, causing a decrease in our aggregate demand. This can be represented as a leftward shift in our aggregate demand curve in the AD/AS model.

Determine the new equilibrium GDP and price level in the AD/AS model

After establishing that the recession in Mexico leads to a decrease in our aggregate demand, we can now use the AD/AS model to determine the likely impact on our equilibrium GDP and price level. A leftward shift in the aggregate demand curve will result in a new intersection point with the aggregate supply curve at a lower level of GDP and a lower overall price level compared to the initial equilibrium.

Interpret the new equilibrium GDP and price level

The decrease in aggregate demand due to Mexico's recession results in a new equilibrium with lower GDP and a lower overall price level in our economy. This implies that our economy will experience a slowdown in economic growth, i.e., a lower GDP, and a decline in the overall price level, which might lead to deflationary pressures. This slowdown and possible deflation can have various effects on individual firms and households in our economy, such as reduced investments, decreased consumption, and an increase in unemployment. In conclusion, a recession in a significant trading partner like Mexico can cause a decrease in aggregate demand in our economy, leading to a decline in both equilibrium GDP and the overall price level. The AD/AS model provides a helpful framework for understanding these economic effects and gives insights into potential areas of concern for policymakers and business leaders to address the negative impacts of reduced trading with Mexico.