Question

Question 1: The AD-AS Model

Suppose the economy is initially in long-run equilibrium, and there is a positive demand shock.

a. Describe the short-run effects of this positive demand shock on output, unemployment,

and prices.

b. Describe how the economy will automatically move back to the potential level of output

in the long run.

c. Illustrate your answers in point (a) and (b) using an AD-AS graph. Show the short-run

effects and the long-run adjustments.

Answer 1

A. A rise in levels of demand or positive demand shock causes the aggregate demand to rise. This can be because of expansionary fiscal policy effect. When the economy is in long run equilibrium (say at price level P1) , the rise in AD (AD1 to AD2) shift the economy to the price level P2 and output level Y2. Which means there is inflation and expansion of GDP. This rise in GDP absorbs some of unemployment rising the level of employment in economy. ( See the diagram at the end to match the points referred.)

B. In long run there is readjust in economy. This readjustment is because of the rising inflation or price levels. As the economy faces a rising inflation, in long run the employed mass starts demanding larger wage rates in order to compensate to the inflation. This leads to laying off of some labour from economy to compensate for the rising prices. This fall is seen by the shift of shirt run aggregate supply curve to the left( SRAS1 - SRAS2) , owing to large demand of high wage rate. This fall in supply further causes inflation and hence the initial level of GDP is achieved but at higher price levels. P3. This is the long run Adjustment.

Diagram for the above discription: