Question

Effects of an Uncertainty Shock (AD/AS Framework) This question attempts to clarify the mechanisms by which an increase in uncertainty about the future economy can affect the economy today, using the AD/AS model. a) Assume that the US economy begins in a situation in which actual GDP (Y) is equal to the potential level of GDP (Yᴾ ). Illustrate this situation in the AD/AS diagram, labeling the initial equilibrium point A. [Hint: recall that actual output is always on the AD and the AS curves]. b) Consider now the IS curve diagram. Suppose that an increase in uncertainty about the future economy causes firms to want to spend less on investment goods (e.g. capital spending) at any given interest rate. How would this shift the IS curve? Explain, using the IS curve diagram. c) Consider now the AD/AS curve diagram. How would the increase in uncertainty about the future economy shift the AD curve? What would be the effect of the change in b) on the short-run equilibrium levels of output and inflation? Explain the intuition and draw the short-run equilibrium point B in the AD/AS diagram.

Answer 1

The effects of an uncertainty shock in the AD/AS framework are illustrated through shifts in the AD and IS curves. It leads to a decrease in aggregate demand, which in turn decreases output and inflation in the short run.

Step-by-step explanation:

To answer this question, we need to understand how an increase in uncertainty about the future economy affects the AD/AS model.

a) In the AD/AS diagram, when actual GDP (Y) is equal to potential GDP (Yp), it represents the initial equilibrium point A. This is because actual output is always on the AD and AS curves.

b) In the IS curve diagram, an increase in uncertainty about the future economy causes firms to want to spend less on investment goods at any given interest rate. This shift in expectations would shift the IS curve leftwards.

c) In the AD/AS curve diagram, the increase in uncertainty about the future economy would shift the AD curve leftwards, reflecting a decrease in aggregate demand. This shift would lead to a decrease in output and a decrease in inflation in the short run. The short-run equilibrium point B would be located where the new AD curve intersects the SRAS curve.