Question

Suppose the economy is initially in the long-run equilibrium, but a drop in consumer confidence causes the AD curve to shift to the left. What will be the impact on prices and output in the short run and long run?

Select the correct answer below:

In the short run, and long run, both prices and output will fall.

In the short run, prices will fall, but output will stay the same. In the long run, both prices and output fall.

In the short run, both prices and output fall. In the long run, prices fall, but output stays the same.

In the short run, and long run, prices fall, but output stays the same.

Answer 1

Initially, the economy was in long-run equilibrium.

However, a drop in consumer confidence has resulted in a leftward shift of the AD curve.

In short-run, given the SRAS curve and LRAS curve, this leftward shift of the AD curve will result in a fall in price level and output.

This fall in output implies a decrease in production which in turn will lead to job losses.

This will increase the unemployment and will push wage rate downward.

As wages will fall, cost of production of firms will decrease. This will increase the profit margin of firms. As profit margin of firms will increase, they will increase their production and thus aggregate output in the economy will increase.

This will shift the short-run aggregate supply (SRAS) curve to the right.

New long-run equilibrum will be achieved. This new long-run equilibrium will move the economy back to its potential output but with lower price level.

Thus,

The correct answer is option (3) [In the short-run, both prices and output fall. In the long-run, prices fall, but output stays the same].