For each of the following situations, use an AD/AS model to describe what happens to price levels and output in the United States in the short run. In each case assume the economy starts in long- and short-run equilibrium, and describe the appropriate shifts in the AS or AD curves. Instructions: You may select more than one answer. Click the box with a check mark for correct answers and click to empty the box for the wrong answers.

a. A stock market crash reduces people’s wealth. Aggregate demand shifts to the left. Aggregate demand shifts to the right. Aggregate supply shifts to the left. Aggregate supply shifts to the right. Output falls. Output rises. The price level rises. The price level falls.

b. The spread of democracy around the world increases consumer confidence in the United States. Aggregate demand shifts to the left. Aggregate demand shifts to the right. Aggregate supply shifts to the left. Aggregate supply shifts to the right. Output falls. Output rises. The price level rises. The price level falls.

c. The European economy crashes. Aggregate demand shifts to the left. Aggregate demand shifts to the right. Aggregate supply shifts to the right. Aggregate supply shifts to the left. Output falls. Output rises. The price level falls. The price level rises.

d. The United States enters into an arms race with China, resulting in a significant increase in military spending. Aggregate demand shifts to the left.

Solution and Explanation:

A) A stock market crash reduces people’s wealth. It will lead to less disposable income into hands and shifts the AD curve to the left. As a result output and price level falls in the short run.

So, aggregate demand shifts to left, output falls, and price level falls.

B) The spread of democracy around the world increases consumer confidence in the US, it will lead to increase n exports and investments as well. There is an inflow of capital which creates a threat for the US currency.

But in the short run the result is as follows:

Aggregate demand shifts to right, price level increases and output level increases.

C) The European economy crashes implies both the sides of the market is affected by this even in the short run. Both the curves will shift down and many automatic stabilizers are at work. On a concluding node, both the curves will shift leftwards and as a result the price level and the output level will fall. The extent of fall is determined only in the long run.

D) The USA enters into an arms race with china, resulting into significant increase in military spending. The immediate effect of this increased in arm manufacturing is increase in unemployment and a result the aggregate supply curve will shift leftwards, the price level in the economy rises and output comes below the natural level.

E) A revolution in Iran results in a significant reduction in world’s supply of oil. Oil is an important raw material and increase in raw material will lead to decrease in aggregate supply. Aggregate supply shifts leftwards, the price level increases and output falls.

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