Assume the economy of Mongolia is in a long run equilibrium with full employment.
A. Draw a correctly labeled graph of short run aggregate supply, long run aggregate supply, and aggregate demand. Show each of the following.
B. Assume there is an increase in consumer spending in Mongolia. On your graph in part A, show the effect this will have on the equilibrium in the short run, labeling the new equilibrium output and price level Y2 and PL2, respectively.
C. What two fiscal policy options does the federal government have to fix the market imbalance? Explain how each would affect the economy.
In a long-run equilibrium with full employment, the aggregate demand (AD) is equal to the long-run aggregate supply (LRAS), determining the equilibrium output and price level. Here’s a description of the graph:
Y-axis: Price Level (P) and Real GDP (Output)
X-axis: Quantity of Output
Short Run Aggregate Supply (SRAS): This curve represents the relationship between the price level and the quantity of output supplied in the short run, assuming all input prices are flexible. It has a positive slope.
Long Run Aggregate Supply (LRAS): This vertical line represents the level of output that can be sustained in the long run, given full employment of resources. It is not influenced by the price level.
Aggregate Demand (AD): This curve shows the total quantity of goods and services demanded at different price levels. It slopes downward, indicating the negative relationship between the price level and the quantity of output demanded.
Equilibrium is where AD intersects both SRAS and LRAS. In this case:
Equilibrium Output (Y1) is where AD intersects LRAS.
Equilibrium Price Level (PL1) corresponds to the price level at this equilibrium output.
B. An increase in consumer spending will shift the aggregate demand curve to the right, resulting in a short-run equilibrium with a higher output and price level:
Equilibrium Output (Y2) is at the intersection of the shifted AD curve and the SRAS curve.
Equilibrium Price Level (PL2) corresponds to the price level at this new equilibrium output.
The federal government has two fiscal policy options to fix the market imbalance:
Expansionary Fiscal Policy: This involves increasing government spending and/or reducing taxes to boost aggregate demand.
Effect on the Economy: Increased government spending directly injects money into the economy, creating demand for goods and services. Tax cuts increase disposable income, leading to higher consumer spending. Both actions shift the AD curve to the right, potentially leading to a new short-run equilibrium with higher output and price level. However, if the economy is already at full employment, this policy can lead to demand-pull inflation.
Contractionary Fiscal Policy: This entails reducing government spending and/or increasing taxes to decrease aggregate demand.
Effect on the Economy: Decreased government spending reduces overall demand for goods and services. Tax increases reduce disposable income and consumer spending. Both actions shift the AD curve to the left, potentially leading to a new short-run equilibrium with lower output and price level. This policy might be used to combat inflation by reducing excessive demand.
In conclusion, Mongolia’s economy, initially in a long-run equilibrium with full employment, can experience short-run fluctuations due to changes in aggregate demand. The government can use expansionary or contractionary fiscal policies to influence aggregate demand and stabilize the economy, aiming to achieve desired output and price level changes while considering potential inflationary or deflationary pressures.
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