Markets and the Economy - Research Paper Example

1996). Due to unemployment and reduced profits, income reduces hence a decline in tax revenue. Tax revenue is thus lower than expenditure resulting in automatic federal budget deficit. The budget deficit resulting from the recession can help to stabilize the economy. Increased government spending in provision of welfare payments is a source of income for households and this result in increased consumption (Hyman, 2010). As consumption increases, aggregate demand increases thereby prompting producers to produce more hence increased output and employment.

The economy thus stabilizes as full employment is reached or aggregate demand equals aggregate supply. Furthermore, improved infrastructure as a result of government spending attracts current and future investments, output growth and employment. Though deficits lead to economy stabilization, there have been concerns about the impact of deficit on national savings. According to Hyman (2010), the financing of deficits by the government from credit markets denies them savings thus inducing increases in interest rates and reduction in private investment hence unemployment and decline in standards of living.

The government should thus engage in spending on areas that produce long-term effects such as investment in education to improve workers skills, building infrastructure to provide future employment among other initiatives. Movement from Short-run Equilibrium to the Long-run Equilibrium The short-run supply indicates the quantity of output produced or Real GDP in an economy at a given period. The relationship between the price level and quantity supplied is depicted by a short-run aggregate supply curve which is upward sloping due to a direct relationship between the two.

The short-run supply is based on the assumption that wages are sticky and that there are misperceptions in the labor market. An increase in price level pushes real wages downwards and since quantity of labor supplied depends on real wages, labor supply declines leading to low output (Arnold, 2010). Workers often have misperceptions about real wages; if the nominal wages fall accompanied by same proportion of a fall in price level then there is no change in real wages but workers may believe that the real wage has fallen thus reduce demand for labor hence quantity of labor supplied falls as well as output.

The equilibrium is reached when aggregate demand curve intersects with short-run aggregate supply. There are other factors that affect short-run supply other than prices. These include wage rates, price of nonlabor inputs, productivity and supply shocks (Arnold, 2010 p. 168). If wage rate increases (stop being sticky), the firm profits decline since the company had already set nominal wages based on constant wage level leading to decline in output or Real GDP as firms are unable to produce more with high costs.

The same case applies to other factors of production such as capital and other inputs. This causes shift in short-run aggregate supply curve to the left. If productivity increases, output increases hence shifting the curve to the right. The intersection between aggregate demand (AD) curve and short-run aggregate supply( SRAS) curve determines the equilibrium price level and equilibrium Real GDP which is also determined by whether AD curve shifts more than SRAS curve or vice versa. When the “