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, the recession in Mexico is likely to cause a decrease in our exports, leading to a decline in our Aggregate Demand (AD). This will result in a leftward shift in the AD curve and a new, lower equilibrium point in the AD/AS model. As a consequence, our equilibrium GDP will decrease, and depending on the slope of the Aggregate Supply (AS) curve, our overall price level may also decrease.

Step-by-step solution

Identify the effect of recession on exports

As Mexico goes into a recession, it is likely to import fewer goods and services due to decreased consumer spending and reduced industrial production. Consequently, our exports to Mexico will decline.

Understand the effect on Aggregate Demand (AD)

A decline in our exports will result in a decrease in our net exports (exports minus imports). Net exports are a component of Aggregate Demand (AD) in our economy, which is calculated using the formula AD = C + I + G + (X - M), where C represents consumption, I denotes investments, G corresponds to government spending, X stands for exports, and M refers to imports. As our net exports decrease, our Aggregate Demand will also decline.

Analyze the AD/AS model

The AD/AS model comprises of two curves - Aggregate Demand (AD) curve and Aggregate Supply (AS) curve. The AD curve shows the relationship between the price level and the quantity of real GDP demanded by households, firms, and the government. The AS curve represents the total quantity of goods and services that firms are willing and able to produce at different price levels. The intersection of these two curves determines the equilibrium GDP and the overall price level in the economy.

Determine the impact on equilibrium GDP and price level

With a decrease in Aggregate Demand due to the decline in our exports, the AD curve will shift to the left. Consequently, the new equilibrium point will be lower compared to the initial equilibrium. This will lead to a decrease in our equilibrium GDP and, depending on the slope of the AS curve, may result in a reduction in the overall price level as well. In conclusion, the recession in Mexico will likely have a negative impact on our equilibrium GDP and may also lead to a decrease in our overall price level, depending on the shape of our AS curve.

Key concepts

Equilibrium GDP

Equilibrium Gross Domestic Product (GDP) is a fundamental concept in economics representing the point at which the total quantity of goods and services produced (aggregate supply) matches the total quantity demanded (aggregate demand) in an economy at a given price level. It's the level of economic output where there's neither an excess of supply causing downward pressure on prices, nor an excess of demand causing inflation.

When external events, such as a recession in a major trading partner, occur, they can disrupt this delicate balance. In the exercise given, as Mexico enters a recession, U.S. exports to Mexico may decrease, leading to a fall in aggregate demand. Consequently, the equilibrium GDP would decline, reflecting a reduction in economic activity as there's less demand for U.S. goods and services internationally.

Aggregate Demand

Aggregate demand (AD) captures the total demand for all goods and services within an economy. It is expressed mathematically by the formula AD = C + I + G + (X - M), where C equals consumer spending, I stands for investment by businesses, G signifies government spending, and (X - M) represents net exports, that is, exports minus imports.

When net exports fall due to conditions like a recession in a trade partner country, the component X of the formula diminishes, hence reducing aggregate demand. This translates into the aggregate demand curve shifting to the left on the AD/AS model, illustrating a decrease in the quantity of goods and services demanded across each price level. As aggregate demand decreases, it usually leads to lower equilibrium GDP and potentially affects price levels, manifesting as deflation if the drop is significant.

Net Exports

Net exports represent the difference between a country’s total value of exports and its total value of imports. It's an essential element of a country's aggregate demand and can significantly impact the balance of trade.

In the context of the given exercise, as Mexico, a significant importer of U.S. products, goes into recession, the U.S. would likely experience a decline in its exports. With fewer goods being sold overseas, net exports will decrease, which in turn reduces aggregate demand. Since exports are a component of aggregate demand, any significant change in net exports can directly affect the economic standing and growth prospects of the exporting country, shaping how equilibrium GDP and price level are determined.

Aggregate Supply

Aggregate supply describes the total output of goods and services that producers are willing to supply at a given overall price level in an economy. It's depicted graphically by an upward sloping curve in the AD/AS model, which suggests that as price levels rise, producers are inclined to supply more goods and services, driven by the higher profits that typically come with higher prices.

In response to a decrease in aggregate demand, such as following a downturn in net exports due to a foreign recession, the intersection point between the aggregate demand and aggregate supply curves moves. This shift can lead to a lower equilibrium GDP. However, if the aggregate supply curve is relatively flat indicating excess production capacity, the price level may not change significantly. Conversely, a steep aggregate supply curve can result in a more pronounced impact on the price level.