Question

Use the aggregate demand–aggregate supply model to illustrate graphically the impact in the short run and the long run of the following changes. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curves shift; v. the short-run equilibrium values; and vi. the long-run equilibrium values. Also, state in words what happens to prices and output in the short run and the long run.

ii) Climate change causes an increase in CO₂ which results in worldwide increase in crop yields.

iii)The government makes its unemployment insurance benefits more generous.

Answer 1

i) increase in crop yields leads to increase in aggregate supply that shifts AS rightwards to AS'. In the short run equilibrium e' output is higher and price is lower.

In long run AS' shifts back to AS. Because when more than potential output is produced wages increase leading to increase in cost of production. Higher cost of production decreases Aggregate supply. In long run price and output increases and decreases respectively to the initial level.

ii) when insurance benefits become more generous supply of labor decreases resulting in higher wages and thus increase in cost of production that shifts AS leftward to AS'. At new short run equilibrium price is higher and output is lower.

Wages fall in the long run because less than full employment output is being produced that increases aggregate supply and shifts the AS' back to AS. In long run price and output decreases and increases respectively to the initial values.