Question

Assume that the US economy is in equilibrium. Now assume that C & Ig decrease because of a drop in consumer and business confidence. Using an AD/AS graph, show the economy in equilibrium and then what happens when confidence drops. Explain the situation the US economy is facing (i.e., a recession) both graphically and in words (hint would you more likely have a deflationary or an inflationary gap in a recession?). Then explain the two options available, both fiscal policy and monetary policy, and how fiscal policy and monetary policy can fix the problem. Be sure to show the result of the policy graphically. (Hint: You won’t have any actual numbers here. Show where the economy is currently operating and where we (policymakers and citizens of the US) would like for it to be operating and then show where we should end up if the stimulus package (fiscal policy) works correctly.)

Answer 1

A. Initial Equilibrium: point A interesection of LRAS, AD1 and SRAS1 curve. Output = Q*

Short Run: AD1 shifts to AD2, new equilibrium at point B (intersection on AD2 and SRAS1). Output = Q1 > initial Q*, price = Ps > initial price

Long Run: SRAS1 shifts to SRAS2, new equilibrium at point C (intersection of AD2, SRAS2 and LRAS). Output = Q*. Price = Pl > Ps > initial price level.

B. Initial Equilibrium: point A interesection of LRAS, AD1 and SRAS1 curve. Output = Q*

Short Run: AD1 shifts to AD2, new equilibrium at point B (intersection on AD2 and SRAS1). Output = Q1 < initial Q*, price = Ps < initial price P*

Long Run: SRAS1 shifts to SRAS2, new equilibrium at point C (intersection of AD2, SRAS2 and LRAS). Output = Q*. Price = Pl < Ps < initial price level P*