Question

Discuss the likely economic incidence of a reduction in teacher salaries in Fairfax County. Discuss both the short-run and the long-run.

Answer 1

A reduction in teacher salaries will decrease consumption demand (since income of the teachers will be lower), thus decreasing aggregate demand which will shift AD curve leftward, lowering price level and lowering real GDP in short run. In long run, lower price level will decrease input costs, making firms increase production and increasing aggregate supply. Short run aggregate supply curve will shift rightward, further decreasing price level and restoring real GDP to original level.

In following graph, initial equilibrium is at point A where AD0 (initial aggregate demand), SRAS0 (initial short-run aggregate supply) and LRAS0 (long run aggregate supply) curves intersect, with initial equilibrium price level P0 and real GDP (= potential GDP) Y0. When AD falls in short run, AD0 shifts left to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1. In long run, SRAS0 shifts right to SRAS1, intersecting AD1 at point C with further lower price level P1 and restoring real GDP to potential GDP of Y0.