Suppose the economy is in long-run equilibrium. In a short span of time, there is an increase in the money supply, a tax decrease, a pessimistic revision of expectations about future business conditions, and a rise in the value of the dollar. In the short run, we would expect
A) the price level and real GDP both to rise.
B) the price level and real GDP both to fall.
C) the price level and real GDP both to stay the same.
D) All of the above are possible.

Question

Quizplus · Accepted Answer

All of the given options are possible depending on the magnitude and direction of the impacts of the individual shocks.

1. An increase in the money supply can lead to a temporary increase in aggregate demand, causing a rise in both price level and real GDP.

2. A tax decrease can also boost aggregate demand as households have more disposable income to spend, leading to a rise in both price level and real GDP.

3. A pessimistic revision of expectations about future business conditions can reduce consumer and business confidence and reduce spending, causing a fall in real GDP. However, its impact on the price level is ambiguous and depends on the relative strength of the demand and supply shocks.

4. A rise in the value of the dollar can make exports more expensive and imports cheaper, reducing net exports and aggregate demand, leading to a fall in real GDP. However, it may also lower the prices of imported goods, causing a fall in the price level.

Thus, depending on the degree and direction of these shocks, any of the given outcomes - rise or fall in both real GDP and price level or no change in either could occur in the short run.

Suppose the Economy Is in Long-Run Equilibrium