s Using an AD/AS model, decide what happens to the price level, the output level
ID: 1104264 • Letter: S
Question
s Using an AD/AS model, decide what happens to the price level, the output level, and unemployment in each of the following cases. Assume that the economy is initially in long-run equilibrium and the events initially catch people by surprise (the changes are unanticipated). Use + to indicate an increase,-to indicate a decrease, and 0 to indicate no change. UNEMPLOYMENT RATE OUTPUT PRICE LEVEL EVENT a. Interest rates fall. b. The stock market crashes. (REAL GDP) c. The dollar depreciates. d. Severe flooding in agricultural areas. e. World oil prices fall (oil is a resource). f. A major technological advance occurs. g. The expected rate of inflation rises. (Hint: This shifts both AD and SRAS.) h. Consumers and businesses become pessimistic about the future direction of the economy i. Foreign economies fall into recession.Explanation / Answer
(a)
Interest rate fall
Fall in interest rate will lower the cost of borrowing. This will induce the households and businesses to borrow more for consumption and investment. So, consumption and investment in economy will increase. These two are the component of aggregate demand. So, there will be increase in aggregate demand as well.
Given the aggregate supply, this increase in aggregate demand will lead to rise in price level and increase in real GDP. When real GDP increases, unemployment rate falls.
So,
Price level will increase (+).
Output will increase (+).
Unemployment rate will fall (-).
(b)
The stock market crashes
Crash in stock market will create negative wealth effect which leads to decrease in consumption by households.
Consumption is a component of aggregate demand. So, this decrease in consumption will lead to decrease in aggregate demand.
Given the aggregate supply, this decrease in aggregate demand will lead to fall in price level and decrease in real GDP. When real GDP falls, unemployment rate rises.
So,
Price level will decrease (-).
Real GDP will decrease (-).
Unemployment rate will increase (+).
(c)
The dollar depreciates.
Depreciation of dollar will make the US exports cheaper and US imports expensive. This will result in an increase in exports and decrease in imports. The net effect of this will be an increase in net exports.
Net exports in a component of aggregate demand. So, this increase in net exports will result in an increase in aggregate demand.
Given the aggregate supply, this increase in aggregate demand will lead to rise in price level and increase in real GDP. When real GDP increases, unemployment rate falls.
So,
Price level will increase (+).
Output will increase (+).
Unemployment rate will decrease (-).
(d)
Severe flooding in agricultural areas
This severe flooding in agricultural areas will lower the agricultural output in the US economy. This in result will lead to decrease in aggregate supply.
Given the aggregate demand, this decrease in aggregate supply will lead to rise in price level and decrease in real GDP. When real GDP falls, unemployment rate rises.
So,
Price level will increase (+).
Output will decrease (-).
Unemployment rate will increase (+).
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