15.1 Graphing Exercise: Extended AD/AS Model

The short-run in macroeconomics is a length of time over which nominal input prices—wages in particular—are fixed, even as the aggregate price level changes. Accordingly, short-run increases in the price level will increase firms' revenues and profits. Such increases expand production and employment beyond the level consistent with "full employment" of resources. However, should prices remain high, workers and other input suppliers will demand increased rewards for supplying their resources. These higher input prices will reduce aggregate supply, restoring unemployment to its natural rate.

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Exploration: How do short-run changes in aggregate demand and supply affect output and the price level in the long run?

The graph shows the economy's aggregate demand curve and both its short-run and long-run aggregate supply curves. The economy is currently at the full-employment long-run equilibrium GDP of Q_f at price level P. To use the graph, drag the aggregate demand or short-run aggregate supply curve left or right by dragging the corresponding label. The full-employment level of GDP can be changed by dragging the blue triangle either left or right. Click on Self Correcting Equilibrium to observe the long-run adjustment to equilibrium; click on AD Policy Adjustment to observe how full employment may be restored using demand-side policy tools.

1. How will an increase in aggregate demand affect GDP in the short run? How does this compare to the long-run change in GDP?
   See answer here
2. Starting from full employment, suppose the economy experiences a dramatic increase in oil prices. How will this affect real GDP and the price level in the short run? Compare and contrast the effects of a "laissez-faire" policy with an active demand-side policy to restore the economy to full employment.
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3. The most recent U.S. recession began in March, 2001, primarily due to a reduction in investment spending by businesses. What are the short-term effects of a decline in investment spending? What would happen in the long run if government did nothing? If government decides to intervene, how should policymakers respond to this type of change in private spending to restore full employment?
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4. Experiment on your own. If there is an increase in long-run aggregate supply, how might the economy achieve a stable price level?
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