2. Applying the AD/AS Model A. A favorable report on the economic outlook improv
ID: 1200402 • Letter: 2
Question
2. Applying the AD/AS Model
A. A favorable report on the economic outlook improves consumers' feelings about the economy. What is the short-run effect of this report? (3 points)
B. What are the short-run and long-run effects of a sharp increase in the price of copper due to a sudden worldwide shortage? (3 points)
C. With a recession looming, households reduce their spending and increase their saving. What are the short-run and long-run effects of this? (3 points)
D. The price of crude oil drops by more than 50% from August to September. What is the short-run effect of this drop? What would need to happen for the long-run effect to be the same as the short-run effect? (3 points)
E. A country repeals its minimum-wage law. What are the short-run and long-run effects of this action? (3 points)
F. A country is in a recession. One of the major political parties proposes significant reductions in both corporate and individual income taxes in order to end the recession. Explain the rationale behind this proposal. (5 points)
Explanation / Answer
(A) The favorable report will increase consumer confidence. This will lead to higher consumption demand, raising the aggregate demand. The AD curve will shift rightward in short run.
This will lead to a higher price level and higher real GDP. Assuming economy was initially at potential GDP level, this will lead to actual GDP being higher than potential GDP, causing a short run expansionary gap causing higher inflation.
(B) Higher price of copper, an input, will raise the cost of production. This will cause aggregate supply to fall in short run, and short run aggregate supply (SRAS) curve shifts leftward, leading to higher price level and lower real GDP in short run.
In the long run, lower availability of input (resource of production) will shift the long-run aggregate supply (LRAS) to the left. Also, higher price level will cause aggregate demand to fall, causing AD to shift leftward. The net effect in long run will be restoration of equilibrium at a point that is at the same price level as before, but at a lower level of real GDP since potential GDP also will fall.
(C) This lowers consumption demand and aggregate demand in short run, causing AD curve to shift left, leading to lower price level and lower real GDP in short run.
In the long run, lower price level lowers the cost of input to firms, so firms increase supply and SRAS curve shifts rightward, intersecting the new AD curve at a lower price level and higher real GDP.
(D) Lower price of oil, an input, will lower the cost of production. This will cause aggregate supply to rise in short run, and short run aggregate supply (SRAS) curve shifts rightward, leading to lower price level and higher real GDP in short run.
In order to short run and ong run effects be the same, this fall in crude price needs to be consistent so that cost of input is lower on a permanent basis.
NOTE: First 4 sub-parts are answered.
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