Question

One of the major shocks to the US economy was the slump in the housing market (note: housing is a major source of consumer wealth for many Americans).

a. Draw the AD-AS model in equilibrium, before the shock. Be sure to label everything. (4 points)

2. The Housing Price Index, published by the Office of Federal Housing Enterprise Oversight, calculates that US home prices fell by an average of 3.0% in the 12 months between January 2007 and January 2008. Illustrate the effect of this shock by shifting the appropriate curve on your diagram in part a. Be sure to label everything. (6 points)

3. How does the economy return to a long-run equilibrium? Explain in words and illustrate on your diagram in part a. Be sure to label everything. (6 points)

Answer 1

Lower price of housing will decrease household wealth. A fall in household wealth lowers consumption expenditure, which decreases aggregate demand, shifting AD curve leftward, decreasing both price level and real GDP in short run and giving rise to a recessionary gap.

In the long run, reduction in price level will reduce the prices of inputs, thus decreasing production costs. Firms will increase output, increasing aggregate supply. SRAS shifts rightward, intersecting new AD curve at further lower price level and real GDP rises to the potential GDP.

In following graph, AD0, LRAS0 and SRAS0 are initial aggregate demand, long-run aggregate supply and short-run aggregate supply curves intersecting at point A with initial price level P0 and real GDP (potential GDP) Y0.

When housing price decreases, AD0 shifts left to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1. Short-run recessionary gap is (Y0 - Y1).

In long run, SRAS0 shifts right to SRAS1, intersecting AD1 at point C with further lower price level P2 and restoring real GDP to potential GDP level Y0.