a) The consumer spending decreases as a result of decline in household wealth.
Implying that the aggregate demand shifts to AD2 from AD21 in the long run while in the equilibrium will remain at E1 in the short-run because the aggregate price level is lower than it is at E1. Therefore, the potential output will be higher than the aggregate output. Moreover, the graphs are examples of a recessionary gap with nominal wages decreasing due to renegotiations. The SRAS will eventually shift to the right (SRAS2) up to the point of intersection of AD2 and E3. until the SRAS2 is reached and it intersects with AD2 at E3. An indication that the economy will reach full potential output at E3 with a less aggregate price (AP) level.
b) In this case the rising consumer spending originate from the increase in disposable income.
Indicating that the (AP) will remain at E1. Therefore, the long run equilibrium will be at E1 thus AD1 will shift to AD2. The potential output being lower than aggregate output, the aggregate price will be higher than E1. Therefore. the short-run equilibrium will be at E2 (Basu & Bundick, 2017). The potential increase in nominal wages and renegotiation of contracts represents an example of an inflationary gap. Moreover, the SRAS curve will continue to shifts towards the left until point SRAS2 where E3 intersects AD2.
c) The effect of the boom in the stock market will raise the worth of shares that households possess.
Therefore, the AD curve will shift towards the right due to the increase in consumer expenditure resulting from the increase stock value. The entire effect will push the economy into an inflationary gap. However, policy makers could employ contractionary fiscal policies to correct the imbalance caused by inflation (Guerzoni & Raiteri, 2015).
d) The government increasing its purchases (spending) such as military equipment due to a natural disaster will cause the AD towards the right.
Thus, the economy will face a recession. The corrective measure could be to use contractionary fiscal policies to curb the recession. Some of the strategies could be reduction of spending on nondefense services and goods, reduced transfers and increase taxes.
e) By the Central Bank reducing the money supply in the economy which leads to an escalation in the interest rates will cause aggregate demand to shift to the left due to decrease in investment spending.
Similar to part (b) above this is an example of a recessionary gap that can be corrected by expansionary fiscal.
References
Basu, S., " Bundick, B. (2017). Uncertainty shocks in a model of effective demand. Econometrica, 85(3), 937-958.
Guerzoni, M., " Raiteri, E. (2015). Demand-side vs. supply-side technology policies: Hidden treatment and new empirical evidence on the policy mix. Research Policy, 44(3), 726-747.
