Exercises: AD-AS Equilibrium and Long-Run Self-Adjustment

Define short-run macroeconomic equilibrium in the AD-AS model. Then say what must be true of AD, SRAS, and LRAS for the economy to be in long-run equilibrium.

Consumer confidence rises sharply and households increase spending. Which curve shifts, and in which direction? Describe the short-run effect on the price level and real GDP.

Define a recessionary gap and an inflationary gap. For each, say whether short-run equilibrium real GDP is above or below full-employment output.

An economy has full-employment output of $\$10{,}000$ billion, but short-run equilibrium real GDP is $\$9{,}600$ billion. (a) Identify the type of gap and its size. (b) Explain what happens to nominal wages and input prices over time if the government does nothing. (c) Describe the resulting shift of SRAS and the final long-run equilibrium price level and real GDP relative to the starting point.

The table below shows an economy's aggregate demand, short-run aggregate supply, and long-run aggregate supply (real GDP in billions of dollars).

(a) Find the initial equilibrium price level and real GDP. (b) Aggregate demand then falls by $\$1{,}000$ billion at every price level. Find the new short-run equilibrium and identify the gap. (c) State the direction in which SRAS will shift in the long run.

A sudden increase in oil prices shifts SRAS to the left in an economy that begins in long-run equilibrium. (a) Describe the effect on the price level, real GDP, and unemployment in the short run. (b) Explain why this situation is a difficult challenge for policymakers. (c) If the government does nothing, describe how the economy eventually returns to long-run equilibrium.

An economy begins in long-run equilibrium. A stock market boom raises household wealth, increasing consumption. (a) Show and explain the effect on AD and on the short-run price level and real GDP. (b) Identify the gap that arises and explain what happens to unemployment relative to the natural rate. (c) Explain how nominal wages and SRAS adjust over time, and describe the final long-run equilibrium compared with the original one. (d) Explain how the Federal Reserve could use contractionary monetary policy to prevent the economy from overheating, and what the likely effect on AD would be.

An economy starts in long-run equilibrium with a price level of 100 and full-employment output of $\$20{,}000$ billion. A negative supply shock moves the short-run equilibrium to a price level of 108 and real GDP of $\$19{,}000$ billion. Policymaker Ava proposes expansionary fiscal policy to restore output. Policymaker Liam proposes doing nothing and waiting. Compare the two options in terms of the price level, real GDP, and unemployment in the short run and the long run. Which option do you think is better, and what assumptions about the speed of wage adjustment does your answer rely on?