In the first graph, the decrease in the stock market asset prices shifts the aggregate demand downwards (to the left). Due to the lower GDP, the aggregate demand curve shifts from D1 to D2 and this creates a new equilibrium point (E2) at the lower price level (Mankiw, 2014). The long-run equilibrium is indicated at the point where all the three lines (LRAS, S1 and D1) intersect one another. In the second graph, there is increased supply; therefore, the short-run aggregate supply curve increases from S1 to S2. This will create a new long-run equilibriums point at a lower price level. Ultimately, the third graph shows the decrease in AD from D1 to D2 due to the decrease in household wealth and also it shows the increase in SRAS curve from S1 to S2 caused by the high supplies. Similarly, the graph shows both the old and new equilibrium points along the LRAS curve. The first equilibrium point is higher than the second one. The shift in the SRAS curve due to high supplies shifted the equilibrium downward along the LRAS curve due to the lower price level. Therefore, the output will also decrease.
In the first graph, Increase in household’s disposable income will increase their spending power. Therefore, at the long-run equilibrium (E1) aggregate demand curve will shift to the right from D1 to D2 since individuals will demand more at every aggregate price level (Mankiw, 2014). In the second graph, the short-run aggregate supply curve will shift in the short-run to the right. Therefore, in the short-run, the economy will be at equilibrium at point E2 and the aggregate price level will be higher than the previous equilibrium (E1). Similarly, the aggregate output will be higher than the potential output. In the third graph, the real GDP is greater than full employment in the short-run. Therefore, the economy should expect prices and nominal wages to increase (Mankiw, 2014). The SRAS curve will shift from S1 to S2 and restore the economy to full employment. The SRAS curve will intersect with the AD2 at a new equilibrium point E3.
In the situation when the stock market boom occurs, the value of the stocks for the household will increase. The aggregate demand will increase since the household will have extra income available (Mankiw, 2014). Similarly, supply will not increase immediately at the same rate hence creating inflation due to increase in prices. The gap that will exist is inflationary. The government will employ contractionary fiscal policy to close the gap. For example, the government can raise taxes to control consumer spending (Mankiw, 2014). Also, the government can decrease its spending, and this will reduce aggregate demand. The contractionary monetary policy can be to increase the interest rate, and this will discourage borrowing from financial institutions.
When the government increases spending, the aggregate demand curve will shift from SRAD1 to SRAD2 (to the right) (Mankiw, 2014). The prices and output will increase, and this will create an inflationary gap. Therefore, the government will employ contractionary monetary policy to move the economy back to the potential level of output (Mankiw, 2014). For example, the government will increase taxes or reduce spending.
The Central Bank will reduce money supply in the economy by increasing the interest rate. The level of investment will reduce, and the aggregate demand will shift to the left from SRAD1 to SRAD2. This will create a recessionary gap. Therefore, the government will use expansionary fiscal policy to move the economy to the potential level of output (Mankiw, 2014). For example, the government will increase spending or reduce taxes.
Mankiw, N. G. R. E. G. O. R. Y. (2014). Principles of macroeconomics. Cengage Learning.
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