Question

Macro Economics

Suppose the economy is in a long-run equilibrium when a temporary, positive (favorable) aggregate supply shock occurs. Using a single AD-AS model, show what happens to bring the economy back to long-run equilibrium when there is a NO policy response. In words, briefly explain why a "no response" policy might be preferable.

Answer 1

AS curve will shift to right and output will increase more than full employment level (Yf) Price will also decrease from P to P' and economy shifts from old equilibrium point A to old equilibrium point B.

Recessionary GDP = Yf-Y'

Eventually, nominal wages will increase and cost of production will increase. Thus aggregate supply will decrease and shift back to original AS and reach same old equilibrium A in absence of any policy response.

Policy response if taken will change other parameters, so there is no need to take any action because economy will automatically reach long run equilibrium point A.