Question Two

Question

Price Level Real GDP demanded Real GDP Supplied
(billions of 2005 dollars) (billions of 2005 dollars)
70 825 375
80 750 450
90 675 525
100 600 600
110 525 675
120 450 750
130 375 825
140 300 900
The table above shows Brownland’s economy aggregate demand and supply schedules. Its potential GDP is $675 billion.
a. Plot the aggregate demand curve, the short-term aggregate supply curve, and the long run aggregate supply curve.
b. What is the short-term equilibrium real GDP and price level in Brownland?
c. What is the long-run equilibrium real GDP?
d. Is the Brownland’s short-run macroeconomics equilibrium a full -employed equilibrium, below full equilibrium, or above full equilibrium? What is the recessionary gap (if any)? What is the inflationary gap (if any)?
e. Suppose aggregate demand increases by $150 billion. Plot the new aggregate demand curve. How do real GDP and the level change in the short run?
f. Is Brownland’s new short-run macroeconomic equilibrium a full - employment equilibrium, below employment full-employment equilibrium, or above full-employment equilibrium? What is the recessionary gap (if any)? What is the inflationary gap (if any)?

Answer 1

To graph and analyze the aggregate demand and supply schedules for Brownland's economy, we can follow these steps:

a. Plot the Curves

Aggregate Demand (AD) Curve: Plot the price levels against the Real GDP demanded. The AD curve slopes downwards.

Aggregate Supply (AS) Curve:

• Short-Run Aggregate Supply (SRAS): It slopes upwards as higher prices incentivize producers to supply more goods.
• Long-Run Aggregate Supply (LRAS): Represents potential GDP, which is vertical at $675 billion.

Using the data from the table:

1. Aggregate Demand Points:

   • (70, 825)
   • (80, 750)
   • (90, 675)
   • (100, 600)
   • (110, 525)
   • (120, 450)
   • (130, 375)
   • (140, 300)

2. Aggregate Supply Points:

   • (70, 375)
   • (80, 450)
   • (90, 525)
   • (100, 600)
   • (110, 675)
   • (120, 750)
   • (130, 825)
   • (140, 900)

Plot these points on a graph with Price Level on the vertical axis and Real GDP (billion 2005 dollars) on the horizontal axis.

b. Short-term Equilibrium

Short-term equilibrium occurs where AD intersects SRAS. From the data:

• At Price Level 100, Real GDP demanded (600) equals Real GDP supplied (600).

Answer:

• Short-term equilibrium price level = 100
• Short-term equilibrium Real GDP = 600 billion dollars

c. Long-run Equilibrium

Long-run equilibrium occurs when AD intersects LRAS, which is at potential GDP of $675 billion.

Answer:

• Long-run equilibrium Real GDP = 675 billion dollars

d. Short-run Equilibrium Analysis

We compare the short-term equilibrium with the potential GDP.

• Short-run equilibrium GDP (600) < Potential GDP (675)

Answer:

• Brownland’s short-run macroeconomic equilibrium is below full-employment equilibrium.
• Recessionary Gap = Potential GDP - Short-run equilibrium GDP = 675 - 600 = 75 billion dollars.
• Inflationary Gap = 0 (there is no inflationary gap since output is below potential).

e. Increase in Aggregate Demand

If aggregate demand increases by $150 billion, the new Aggregate Demand points would be adjusted. The new AD schedule can be calculated by adding $150 billion to the Real GDP demanded at each price level.

New Aggregate Demand Points:

• Price Level 70 -> 825 + 150 = 975
• Price Level 80 -> 750 + 150 = 900
• Price Level 90 -> 675 + 150 = 825
• Price Level 100 -> 600 + 150 = 750
• Price Level 110 -> 525 + 150 = 675
• Price Level 120 -> 450 + 150 = 600
• Price Level 130 -> 375 + 150 = 525
• Price Level 140 -> 300 + 150 = 450

Graph the new AD curve.

With the new AD curve, the short-run equilibrium will shift up.

We can analyze it by observing intersections of the new AD with SRAS.

Using the new values, the new equilibriums are:

• At the price level of 100:
  • Real GDP demanded (750) > Real GDP supplied (600).

At the price level of 110:

• Real GDP demanded (675) < Real GDP supplied (675).

f. New Short-run Equilibrium Analysis

Following the increase in AD, let’s analyze the new equilibrium:

• Assume the new short-run equilibrium occurs at Price Level 110, where AD = $675 billion, which equals SRAS.

Answer:

• The new short-run macroeconomic equilibrium is at a level (not at full employment) since it can take time for the economy to achieve potential GDP of $675 billion.

Recessionary Gap: 0 (since it meets potential GDP when at Price Level 110 with demand) Inflationary Gap: No (since the equilibrium is not over full employment).

Conclusion

• Before the demand shock, Brownland was in a recessionary gap.
• Post shock, the economy may adjust closer to full employment, but if demand continues to rise, the economy could face inflationary pressures moving towards the long run equilibrium.