Question

Use the AD-SRAS-LRAS model and diagram of chapter 10 to explain the economy’s likely transition to a major stock market decline that reduces the wealth of U.S. consumers. Show both long run and short run outcomes for the case where the AS is upward sloping and the case where AS is horizontal

Answer 1

In short run after major stock market decline, there is decrease in net wealth of people which reduce consumption as well as investment which result in decrease in aggregate demand and shift demand curve to its left from AD to AD1 which result in decrease in price level from P to P1 and decrease in output from Y to Y1.

In long run, producers will try to reduce their supply as consumers have reduced their demand which will shift supply curve to its left and result in increase in price to its initial level while output level fall further.

When supply curve is vertical:

Leftward shift of demand curve in short run result in decrease in price level while output remains same.

In long run, supply curve will shift to its left,