Question

A country is initially at the long-run and short-run equilibrium. However, in the short-run, the
country experiences a drop in the general price level and the real GDP at the same time due to a
temporary shock and we know there is one shock only.
(a) Which curve(s) in the LRAS-SRAS-AD diagram must have shifted to generate the observation
above? If any of the curves has shifted, state the direction of the shift, propose a factor that leads
to the shift of the curve and state clearly whether the factor has increased or decreased.
(b) Without any intervention from the government or the Central Bank, we know that the country
will adjust to the new long-run equilibrium through labor contract renewal.
During the adjustment process,
(i) which curve(s) in the LRAS-SRAS-AD diagram will shift and in what direction?
(ii) how will the real GDP, unemployment rate and the general price level change during
the adjustment process?

Answer 1

(a)

A decrease in both price level and real GDP occurs from a negative demand shock where aggregate demand falls. For example, a decrease in investor confidence decreases investment, which decreases aggregate demand, shifting AD curve leftward and decreasing both price level and real GDP in short run. Unemployment rate will fall.

In following graph, initial full-employment equilibrium is at point A where AD0 (aggregate demand), LRAS0 (long-run aggregate supply) and SRAS0 (short-run aggregate supply) curves intersect with initial equilibrium price level P0 and initial equilibrium real GDP (= potential GDP) Y0. When aggregate demand falls, AD0 shifts left to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1 in short run.

(b)

(i)

In the long run, lower price level will decrease prices of inputs, 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 being restored to the potential GDP.

In above graph, 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.

(ii)

Compared to short run equilibrium, price level will be lower, real GDP will be higher and unemployment will be lower.

Compared to initial long-run equilibrium, price level will be lower, real GDP will be unchanged and unemployment will be unchanged.