Answer to Question #158029 in Macroeconomics for Laiq Khan

Question

Due to COVID-19 situations the oil prices fall in international market. Let’s assume that output starts at its natural level.

a. What happens to the Pakistan’s economy (output and price) in the short run? Explain your answer using AS-AD graphs. (2.5 Marks, Maximum 150 words)

b. What happens to Pakistan’s economy (output and price) in the long run? Explain your answers using graphs. (2.5 Marks, Maximum 150 words)

Answer 1

Changes in aggregate supply and aggregate supply affect the economic situation in the country.

Consider this impact on an example of an increase in aggregate demand (figures below). The consequences of an increase in demand increase depending on how the state of the economy corresponds to the segment of the aggregate supply curve.

If the intersection of the curves of aggregate demand and aggregate supply occurred in the Keynesian segment, then the growth of aggregate demand to the real scale of national production without increasing the level; if on the classic, the growth of total income to the growth of the price level with the same volume of production; if in fact there is an increase in the real volume of national production and an increase in the price level.

This is of great importance for answering the question: can and should economic growth be stimulated? By sublimating the aggregate demand, measures of influence on it by the state.

For a more complete characterization of potential GDP, it is necessary to pay attention to such an indicator as potential GDP. The concept of potential GDP based on the idea of ​​full employment, that is, the full use of resources (factors of production) in production, including labor. But even such an ideal state of the economy does not guarantee that it will be in equilibrium all the time. Equilibrium can be reached at a point that can be above, below and equal to GDP.

When equilibrium short-term aggregate production falls below GDP, we call this a recession gap.

At the first stage, in which the economy in the short term operates at a level below GDP. Possible GDP is represented by real GNP, if all factors of production were fully employed, then graphically it should represent the curve of total production as a vertical. In this case, between the actual and potential GDP, the total losses from the underutilization of all resources, that is, the recession gap. The recessionary GDP gap is associated with low demand, which has a depressing effect on prices.

However, a short-term reverse situation is possible, in which it functions in such a way that the equilibrium short-term total production of GDP. This situation is called the inflationary gap. It reflects the presence of strong unexpected demand, which puts increased pressure on prices, resources (and, therefore, on costs). A short-term expansion of demand also for a short period leads to an expansion of production, and it goes beyond GDP, as the second figure shows.