Scenario
You are a member of the president's Council of Economic Advisers for the country of Manulo. Currently the economy of Manulo is operating at full employment, but a new crisis has hit the nation of Zedland, a major trade partner. Zedland's unemployment has hit record highs and stock market has crashed unexpectedly. Your team must analyze how this external shock may impact the economy in Manulo. Prepare a brief report that answers the following questions: 1. Which curve, aggregate demand (AD), short run aggregate supply (SRAS) or long run aggregate supply (LRAS) would immediately shift in response to the crisis in Zedland? In which direction (left or right? Explain your rationale. In other words, why does the curve shift?
- Compare the expected movements in equilibrium GDP and price level in the short run. In other words, compared to the starting point (before the shift) what happened to output and price level (increased, decreased or stayed the same) and after the shift?
- Compare the expected movements in equilibrium GDP and price level in the long run. In other words, compared to the starting point (before the shift) what happened to output and price level (increased, decreased or stayed the same) and after the shift in the long run?
- The president wants you to explain how does the economy of Manulo transition from the short run equilibrium to the long run equilibrium so he can decide whether to put together an economic policy response. In other words, what is the difference between the long run and the short run and how does an economy move from one equilibrium to the other?
Analyzing the Impact of Zedland's Crisis on the Economy of Manulo
As a member of the president's Council of Economic Advisers in the country of Manulo, it is crucial to assess how the external shock from Zedland's crisis may affect the economy. Below is a brief report addressing the key questions posed:
1. Impact on Aggregate Demand (AD), Short-Run Aggregate Supply (SRAS), and Long-Run Aggregate Supply (LRAS):
- Immediate Shift: The crisis in Zedland would likely lead to a decrease in demand for goods and services from Manulo. This would cause a leftward shift in the aggregate demand (AD) curve, as lower demand from Zedland reduces exports and overall spending in Manulo.
- Rationale: The decrease in Zedland's economic activity results in lower demand for imports, affecting Manulo's export-oriented industries and reducing overall aggregate demand.
2. Expected Movements in Equilibrium GDP and Price Level in the Short Run:
- Output and Price Level: In the short run, the leftward shift in AD would lead to a decrease in equilibrium GDP as demand weakens. The reduction in demand may also put downward pressure on prices, leading to a decrease in the price level compared to the initial equilibrium point before the shock.
3. Expected Movements in Equilibrium GDP and Price Level in the Long Run:
- Output and Price Level: In the long run, the economy of Manulo would adjust to the shock from Zedland. With time, wages, input costs, and expectations would adapt, leading to an increase in SRAS as the economy adjusts back towards full employment. Equilibrium GDP may return to its original level, but with a lower price level due to decreased demand.
4. Transition from Short-Run to Long-Run Equilibrium:
- Difference: The key difference between short-run and long-run equilibrium lies in price and wage flexibility. In the short run, prices and wages may be sticky, leading to shifts in AD impacting output and prices. However, in the long run, prices and wages adjust, allowing the economy to reach its natural level of output.
- Transition Process: To move from short-run to long-run equilibrium, the economy of Manulo would need to undergo adjustments. Price and wage flexibility, along with market forces, would drive these adjustments over time, leading to a restoration of equilibrium GDP and price levels.
In conclusion,
understanding the dynamics of external shocks on the economy of Manulo is crucial for formulating effective policy responses. By analyzing the short-run and long-run implications of Zedland's crisis, policymakers can make informed decisions to support economic stability and growth in Manulo amidst challenging external conditions.