Changes in Equilibrium: Aggregate Demand Shocks 5. Suppose that in an effort to

Question

Changes in Equilibrium: Aggregate Demand Shocks 5. Suppose that in an effort to reduce the cur 7. In a January 9, 2010, article the Wall Street rent federal government budget deficit, the White House decides to sharply decrease government spending. Assuming the econ omy is at its long-run equilibrium, carefully explain the short- and long-run consequences of this policy Journal reported that "inflation-adjusted wages have slumped during 2009." Is this statement consistent with the aggregate demand and supply analysis of the recent U.S. economic crisis? Explain 6. According to aggregate demand and supply analysis, what would be the effect of appointing a Federal Reserve System chairman known to have no interest in fighting inflation?

Explanation / Answer

Answer to first question has been provided :

5) Sharly decreasing the government spendind is a form of contractionary fiscal policy . This decreases the Aggregate Demand in the economy . Government spending (G) is a component of Aggregate Demand (AD). The AD curve shifts left . So the potential output and price level both fall in short run . A deflationary gap is created . This would lead to lower economic growth and lower inflation .

In the long run the economy adjusts because the long run aggregate supply curve shifts backwards . Since there is lower inflation or fall in aggregate demand , so in the long run supply falls in the economy . Producers produce less due to less demand in the short run . So the economy adjusts and reaches equilibrium at a lower price level .

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