Question

Suppose that laws are passed banning labor unions and that resulting lower labor costs are passed along to consumers in the form of lower prices. Use the aggregate demand–aggregate supply model to illustrate graphically the impact in the short run and the long run of this favorable supply shock. 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. State in words what happens to prices and output in the short run and the long run.

Answer 1

Effects of a positive supply shock :

Lower labour costs means that input costs have fallen , so supply will rise . Short run aggregate supply curve shifts to the right . In short run , price level decreases and output increases as new short run aggregate supply curve is the rightward shift of the old one and cuts the aggregate demand curve at lower intersection .

As the economy starts to adjust in long run , the output potential has increased since firms can hire more labour now . So LRAS also shifts right .