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Explain and use two separate AS/AD diagrams to show the initial (short-run) effect and the money...

Explain and use two separate AS/AD diagrams to show the initial (short-run) effect and the money wage adjustment (long-run) effect of an increase in aggregate demand.

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Answer #1

Increase in aggregate demand shifts AD curve rightwards to AD'. New short run equilibrium is reached at e' resulting in equilibrium output from Y to Y' and increase in price from P to P'.

In long run when output produced is greater than full employment level wage rate increases which increases the cost of production. This lowers the aggregate supply shifting the AS leftwards to AS'. Long run equilibrium reaches at e''. This leads to decrease in output back to Y and further increase in price to P''.

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