Use graphical analysis to show how each of the following...

Use graphical analysis to show how each of the following would affect the economy first in the short run and then in the long run. Assume that the United States is initially operating at its full-employment level of output, that prices and wages are eventually flexible both upward and downward, and that there is no counteracting fiscal or monetary policy. a. Because of a war abroad, the oil supply to the United States is disrupted, sending oil prices rocketing upward. b. Construction spending on new homes rises dramatically, greatly increasing total U.S. investment spending. c. Economic recession occurs abroad, significantly reducing foreign purchases of U.S. exports.

Use graphical analysis to show how each of the following would affect the economy first in the short run and then in the long run. Assume that the United States is initially operating at its full-employment level of output, that prices and wages are eventually flexible both upward and downward, and that there is no counteracting fiscal or monetary policy.
a. Because of a war abroad, the oil supply to the United States is disrupted, sending oil prices rocketing upward.
b. Construction spending on new homes rises dramatically, greatly increasing total U.S. investment spending.
c. Economic recession occurs abroad, significantly reducing foreign purchases of U.S. exports.

Key Concepts

Investment Spending

Investment spending, such as increased construction activity, directly influences aggregate demand by increasing total spending in the economy. This boost in demand can lead to higher output and prices in the short run while potentially affecting long-run growth prospects if it is sustainable. The analysis tracks how an increase in investment shifts the aggregate demand curve and its implications for both short-run output and long-run potential growth.

Aggregate Demand and Supply Model

This model explains the overall price level and output in an economy by showing the interactions between aggregate demand (total spending) and aggregate supply (total production). It is used to analyze short-run fluctuations and long-run adjustments, illustrating how economic shocks or policy decisions shift the curves and influence equilibrium output and prices.

Short-run vs Long-run Adjustments

In the short run, some prices and wages are sticky, meaning they do not adjust immediately to changes in economic conditions. This can lead to temporary deviations from full employment output. In the long run, however, prices and wages adjust fully, which allows the economy to return to its natural level of output, even though the path to that equilibrium may involve inflation or deflation.

Supply Shocks

A supply shock refers to an unexpected event that suddenly changes the cost of production inputs, thereby shifting the short-run aggregate supply (SRAS) curve. A negative supply shock, such as an abrupt increase in oil prices, raises production costs, reducing output and increasing prices in the short run. Over time, adjustments in wages and prices shift the SRAS back, ultimately affecting the long-run equilibrium.

Net Exports and Foreign Demand

Net exports, which are the difference between a country’s exports and imports, play a key role in aggregate demand. Changes in foreign economic conditions, such as a recession abroad, can reduce the demand for a country's exports, thus shifting the aggregate demand curve to the left. This reduction in demand influences both short-run output and prices and has long-run effects as the economy adjusts to lower external demand.

Transcript

00:01 Let's use our aggregate demand and supply model to show how each of the following shocks would affect our economy first in the short run and then in the long run.

00:10 All right.

00:10 So first we have a situation where a war abroad has caused the oil supply to the u .s.

00:15 To be disrupted and oil prices have rocketed upward.

00:19 So if our overall supply for production has decreased, right, that's going to shift our, so i'll draw a shift in red, our short run aggregate supply curve to the left, right? so while the war is going on, prices are going to be higher at each level of gdp, right, because it's going to cost more for our inputs for our oil.

00:37 So we're shifting sras to the left.

00:40 Right.

00:41 So first let's, so this was our equilibrium point.

00:44 At the start, right, we had our p star, our original price level and our y star are original gdp when we're at full employment.

00:51 Right.

00:52 So now we're shifting sras to the left.

00:54 So our short run equilibrium is going to be where our short run aggregate supply is.

00:59 Aggregate demand intersect.

01:01 So that's going to be right up here.

01:04 So what that is, so this has, the shock has increased our price level.

01:10 So it's increased our price level and it has also decreased our gdp below our potential, right? so current gdp is less than potential.

01:20 Right.

01:21 And so what that will do is that'll signal to our firms, right, that prices have gone up, right? and demand has gone down from originally, right, because we are producing at a quantity lower than our potential gdp.

01:37 So in the long run, what firms will do is they're going to adjust their prices.

01:41 They're going to bring their prices down to react to this decrease in demand.

01:46 So they're going to decrease their prices, and that is going to slowly shift our aggregate supply back to our original equilibrium point.

01:55 Right? so in the short run, we'll be in a recession because gdp will be less than potential.

02:00 But then firms will realize that since gdp is less than potential, they can decrease prices to react to this lower demand, bringing us back to our original equilibrium.

02:10 Okay.

02:11 So i'm going to reset our model so we can look at the next situation.

02:18 Okay.

02:19 All right.

02:19 So in this situation, we have that construction, excuse me, construction spending has risen, which has greatly increased total investment spending.

02:29 All right, so investment spending is part of our aggregate demand expenditure, right? gdp is equal to consumption plus investment plus government spending plus net exports, right? so if we start at this point right here and we're going to increase our aggregate demand, right, because we have an increase in investment.

02:49 So if we shift our aggregate demand curve to the right, then we're going to find our new intersection in the short run to be where sris and ad intersect...

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