Question

 For the following four cases, trace the impact of each shock in the aggregate demand and aggregate supply model by answering the following three questions for each: i. What happens to prices and output in the short run?

 ii. What happens to prices and output in the long run if the economy is allowed to adjust to long-run equilibrium on its own?

 iii. If policy makers had intervened to move output back to the natural rate instead of allowing the economy to self-correct, in which direction should they have moved aggregate demand?

 Shock 1: Aggregate demand shifts left

 For the following four cases, trace the impact of each shock in the aggregate demand and aggregate supply model by answering the following three questions for each: i. What happens to prices and output in the short run?

 ii. What happens to prices and output in the long run if the economy is allowed to adjust to long-run equilibrium on its own?

 iii. If policy makers had intervened to move output back to the natural rate instead of allowing the economy to self-correct, in which direction should they have moved aggregate demand?

 Shock 1: Aggregate demand shifts left

 For the following four cases, trace the impact of each shock in the aggregate demand and aggregate supply model by answering the following three questions for each: i. What happens to prices and output in the short run?

 ii. What happens to prices and output in the long run if the economy is allowed to adjust to long-run equilibrium on its own?

 iii. If policy makers had intervened to move output back to the natural rate instead of allowing the economy to self-correct, in which direction should they have moved aggregate demand?

 Shock 3: Short-run aggregate supply shifts left

 For the following four cases, trace the impact of each shock in the aggregate demand and aggregate supply model by answering the following three questions for each: i. What happens to prices and output in the short run?

 ii. What happens to prices and output in the long run if the economy is allowed to adjust to long-run equilibrium on its own?

 iii. If policy makers had intervened to move output back to the natural rate instead of allowing the economy to self-correct, in which direction should they have moved aggregate demand?

 Shock 4: Short-run aggregate supply shifts right

Answer 1

The shocks and their impacts are as follows:

Shock 1: Aggregate demand shifts left

The situation is explained graphically below:

i. If aggregate demand shifts leftward (AD to AD'), it means that the overall demand of the good has decreased. This would mean that in the short run, the firm would reduce prices (P₁ to P₂) and the output will also decrease (Q₁ to Q₂).
ii. If aggregate demand shifts leftward and the economy adjusts to long-run equilibrium on its own, then, in the long-run, the price will reduce but the output will adjust on its own in the long run and return to its natural position (Q₁ at equilibrium point E).  
iii. Since, the aggregate demand has shifted to the left, the policy makers would intervene to move the output back to its natural rate by introducing policies which would shift the aggregate demand curve back in the rightward direction (AD' to AD).

Shock 3: Short run aggregate supply shifts left

The situation is explained graphically below:

i. If short-run aggregate supply shifts leftward (AS to AS'), it means that the overall supply of the good has decreased. This would mean that in the short run, the price of the good will increase (P₁ to P₂) and the output will decrease (Q₁ to Q₂).
ii. If short-run aggregate supply shifts leftward and the economy adjusts to long-run equilibrium on its own, then, in the long-run, the price level will decrease to its natural level (P₁) and the output will also adjust on its own and will increase and return to its natural position (Q₁ at equilibrium point E).  
iii. Since, the short-run aggregate supply has shifted to the left, the policy makers would intervene to move the output back to its natural rate by introducing policies which would shift the aggregate supply curve back in the rightward direction (AS' to AS).

Shock 4: Short run aggregate supply shifts right

The situation is explained graphically below:

i. If short-run aggregate supply shifts rightward (AS to AS'), it means that the overall supply of the good has increased. This would mean that in the short run, the price of the good will decrease (P₁ to P₂) and the output will increase (Q₁ to Q₂).
ii. If short-run aggregate supply shifts rightward and the economy adjusts to long-run equilibrium on its own, then, in the long-run, the price level will increase to its natural level (P₁) and the output will also adjust on its own and will reduce and return to its natural position (Q₁ at equilibrium point E).  
iii. Since, the short-run aggregate supply has shifted to the right, the policy makers would intervene to move the output back to its natural rate by introducing policies which would shift the aggregate supply curve back in the leftward direction (AS' to AS).