Short Run AD/AS Review and Long-Run Adjustments Study Guide

Short Run AD/AS Review and Long-Run Equilibrium in Canada

• Economic Context: Canada is categorized as an open economy. In the initial scenario provided, the economy is currently operating in a state of long-run equilibrium.
• Graphing the Long-Run Equilibrium:     - A correctly labeled graph for this scenario includes three primary curves: Long-Run Aggregate Supply ($LRAS$), Short-Run Aggregate Supply ($SRAS$), and Aggregate Demand ($AD$).     - Vertical Axis: Labeled as Price Level ($PL$).     - Horizontal Axis: Labeled as Real Gross Domestic Product ($RGDP$).     - Initial Equilibrium Point: All three curves ($AD$, $SRAS$, and $LRAS$) intersect at a single point.     - Current Price Level ($PL_1$): Marked on the vertical axis at the intersection point of the three curves.     - Current Output ($Y_1$): Marked on the horizontal axis at the intersection point.     - Full Employment Output ($Y_f$): In this specific long-run scenario, the current equilibrium output ($Y_1$) is equal to the full employment output level ($Y_f$).

Impact of Business Uncertainty on Aggregate Demand and Employment

• Scenario Overview: An economy is initially in long-run equilibrium. The scenario then introduces increased uncertainty leading to a reduction in business orders for equipment.
• Aggregate Demand ($AD$) Impact:     - Change: Aggregate demand decreases.     - Explanation: The reduction in business orders represents a decline in investment spending, a core component of $AD$. Because businesses are facing uncertainty, they reduce their demand for capital goods (equipment). This causes the $AD$ curve to shift to the left.
• Employment Impact:     - Change: Employment decreases (or unemployment increases).     - Explanation: As businesses demand fewer goods and services, production levels fall. This creates a decrease in the demand for labor to produce that output.
• Graphic Representation of the Shock:     - The $AD$ curve shifts left from $AD_1$ to $AD_2$.     - The short-run equilibrium output level moves from $Y_1$ to a lower level, $Y_2$, located to the left of the $LRAS$ curve.     - The price level decreases from $PL_1$ to $PL_2$.

Effects of International Trade Recessions on Country Alpha

• Initial Condition: Country Alpha is operating at full-employment equilibrium, where the intersection of $AD$ and $SRAS$ occurs exactly on the vertical $LRAS$ line.
• Exogenous Shock: Country Beta, which is a major trading partner of Alpha, enters an economic recession.
• Impact on Country Alpha's Aggregate Demand ($AD$):     - Change: $AD$ decreases.     - Explanation: A recession in Beta means that consumer income in Beta is falling. Consequently, Beta will purchase fewer imports from Alpha. This results in a decrease in Alpha's Net Exports ($NX$), leading to a leftward shift in Alpha's aggregate demand curve.
• Impact on Real Output and Price Level:     - On the graph, the new short-run equilibrium is found where the new, shifted $AD_2$ curve intersects the original $SRAS$ curve.     - Real Output ($Y_2$): The output level decreases (Y_2 < Y_1).     - Price Level ($PL_2$): The price level decreases (PL_2 < PL_1).

Fiscal Policy and the Balanced Budget Multiplier in Zarland

• Initial Economic State: Zarland is operating below the full-employment level of output. This means it is in a recessionary gap where the current equilibrium ($Y_1$) is to the left of the full-employment output level ($Y_f$).
• Budget Status: The country is currently maintaining a balanced budget.
• Policy Action: The government of Zarland decides to increase government expenditures and taxes by equal amounts.
• Analysis of Spending Change on Output and Price Level:     - Even though the increase in government spending ($G$) and the increase in taxes ($T$) are equal, the net effect on the economy is expansionary. This is due to the Balanced Budget Multiplier.     - The government spending multiplier ($1/MPS$) is stronger than the tax multiplier ($-MPC/MPS$) because spending enters the circular flow directly, while a portion of a tax cut/increase would have been saved by consumers rather than spent.
• Graphic Representation of Policy Effect:     - Aggregate Demand ($AD$): The $AD$ curve shifts to the right.     - Real Output: There is an increase in real output, moving from $Y_1$ toward the full-employment level ($Y_f$).     - Price Level: The shift results in an increase in the price level from $PL_1$ to $PL_2$.