Use an aggregate demand and supply diagram to explain how each of the following scenarios affects the equilibrium price level and aggregate output. Consider first the short-run, then the long-run equilibrium for each scenario.
a) Consumers expect a recession, while resource prices rise at the same time.
b) Foreign income falls as domestic technology improves.
c) Foreign price level rises as domestic government cuts taxes.
d) Government spending falls and a higher future price level is expected.
e) Higher future income and lower price level are expected.
f) Resource prices fall and technology improves.
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To analyze these scenarios using an aggregate demand and supply diagram, let's start by understanding the components of the diagram.
In an aggregate demand and supply diagram, the horizontal axis represents the total quantity of output, and the vertical axis represents the overall price level. The aggregate demand curve slopes downward, indicating the relationship between the price level and the quantity of output demanded in the economy. The aggregate supply curve slopes upward, indicating the relationship between the price level and the quantity of output supplied.
Now let's examine each scenario and its impact on the equilibrium price level and aggregate output in both the short run and the long run.
a) Consumers expect a recession, while resource prices rise at the same time:
In the short run, consumer expectations of a recession will lead to a decrease in aggregate demand. This will shift the aggregate demand curve to the left, resulting in a lower equilibrium price level and a decrease in aggregate output. However, since resource prices rise, the aggregate supply curve will shift to the left as well, further decreasing output and potentially leading to higher prices. The combined effect will result in a lower equilibrium price level and a decrease in aggregate output.
In the long run, the increase in resource prices will result in higher production costs for firms. As a result, the aggregate supply curve will continue to shift to the left, decreasing output and potentially leading to higher prices. The eventual adjustment in the long run will result in a lower equilibrium price level and a decrease in aggregate output compared to the initial equilibrium.
b) Foreign income falls as domestic technology improves:
In the short run, domestic technology improvements will increase domestic productivity, leading to a decrease in production costs and an increase in aggregate supply. This will shift the aggregate supply curve to the right, resulting in a higher equilibrium price level and an increase in aggregate output. On the other hand, a decrease in foreign income will reduce aggregate demand, shifting the aggregate demand curve to the left, potentially offsetting the increase in output. The overall effect will depend on the relative magnitudes of the shifts in aggregate demand and supply.
In the long run, the improvement in domestic technology will continue to increase productivity and lower costs. This will further shift the aggregate supply curve to the right, resulting in a higher equilibrium output and potentially lower prices. The decrease in foreign income, if persistent, will continue to impact aggregate demand and may further lower output. The long-run adjustment will lead to a higher equilibrium output and uncertain effects on the price level.
c) Foreign price level rises as domestic government cuts taxes:
In the short run, the government's tax cuts will increase disposable income and consumer spending, leading to an increase in aggregate demand. This will shift the aggregate demand curve to the right, resulting in a higher equilibrium price level and an increase in aggregate output. Simultaneously, the rise in the foreign price level will increase the cost of imports and potentially reduce net exports, which can partially offset the increase in output.
In the long run, the initial increase in aggregate demand due to tax cuts will create upward pressure on prices. Additionally, the rise in the foreign price level will continue to increase import costs, negatively affecting net exports. These factors, along with potential inflationary pressures, can reduce aggregate supply and shift the aggregate supply curve to the left, leading to a higher equilibrium price level and uncertain effects on aggregate output.
d) Government spending falls and a higher future price level is expected:
In the short run, a reduction in government spending will decrease aggregate demand, shifting the aggregate demand curve to the left. This will result in a lower equilibrium price level and a decrease in aggregate output. The expectation of a higher future price level may prompt consumers to increase their current spending, partially offsetting the reduction in demand and its impact on output.
In the long run, the reduction in government spending will decrease aggregate supply. This can occur when public investment, infrastructure, or education spending is reduced, leading to lower productivity and potential supply constraints. The decrease in aggregate supply will shift the aggregate supply curve to the left, further reducing output and potentially increasing prices. The adjustment in the long run will result in a lower equilibrium price level and a decrease in aggregate output compared to the initial equilibrium.
e) Higher future income and lower price level are expected:
In the short run, the expectation of higher future income will increase consumer spending and aggregate demand. This will shift the aggregate demand curve to the right, resulting in a higher equilibrium price level and an increase in aggregate output. The expectation of a lower price level can also increase spending, further boosting aggregate demand and potentially offsetting any decline in output.
In the long run, the expectation of higher future income will drive investment and productivity improvements, positively affecting aggregate supply. This will shift the aggregate supply curve to the right, leading to higher output and potentially lower prices. The expectation of a lower price level can encourage savings and investment, further increasing productivity and output. The long-run adjustment will result in a higher equilibrium output and uncertain effects on the price level.
f) Resource prices fall and technology improves:
In the short run, the decrease in resource prices will lower production costs, leading to an increase in aggregate supply. This will shift the aggregate supply curve to the right, resulting in a lower equilibrium price level and an increase in aggregate output. Simultaneously, technological improvements will also increase productivity and further shift the aggregate supply curve to the right, potentially enhancing the positive impact on output.
In the long run, the decrease in resource prices and technological improvements will continue to increase productivity and lower costs, further shifting the aggregate supply curve to the right. This will result in a lower equilibrium price level and a higher aggregate output compared to the initial equilibrium.
Overall, these scenarios illustrate how changes in consumer expectations, government policies, foreign factors, and resource prices can affect the equilibrium price level and aggregate output in both the short run and the long run.