Question

Suppose the economy is in a long-run equilibrium when a temporary, favorable aggregate supply shock occurs. Using graphs, show what happens to bring the economy back to long-run equilibrium, assuming that there is no policy response. In words, explain why no response is the best policy

Answer 1

Suppose the economy is initially at e with full employment level of output at Y*.

Favourable aggregate supply shock shifts the AS curve to the right to AS'. New short run equilibrium is reached at e' with higher level of output at Y' and lower prices at P'.

In long run cost of production rises because when more than full employment level of output is produced wage rate tends to increase which leads to decrease in aggregate supply back to AS with long run equilibrium at e.

answered by: anonymous