Question

The stock market declines sharply, reducing consumers’ wealth. What are the short-run and long-run effects on output and the price level?

a. In the short-run, output increases and the price level decreases. In the long-run, output returns to
its original level while the price level is lower than it was initially
b. In the short-run, both output and the price level decrease. In the long-run, output returns to its
original level while the price level is lower than it was initially
c. In the short-run, output decreases and the price level increases. In the long-run, output returns to
its original level while the price level is higher than it was initially
d. In the short-run, both output and the price level decrease. In the long-run, output and the price
level return to their original levels

Answer is B, but why? And why in the long run does price level stay lower than it was initially instead of returning to the original level?

Answer 1

Option (B).

A fall in consumer wealth will increase consumption demand, which will decrease aggregate demand in short run. The AD curve will shift leftward, decreasing both price level and real GDP in short run. In the long run, lower price level will decrease the cost of inputs, which lowers cost of production. Therefore producers increase production and output which increases aggregate supply. Short run aggregate supply curve shifts rightward, intersecting new AD curve at a further lower price level but restoring real GDP at its original level.

In following graph, AD0, SRAS0 and LRAS0 are initial aggregate demand, short run aggregate supply and long run aggregate supply curves intersecting at point A with initial 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 P2 but restoring real GDP to Y0.