Question

If there is a permanent decrease in my potential output and also my AS curve shifts...

If there is a permanent decrease in my potential output and also my AS curve shifts left do to an inflation shock, what will happen in the short run and the long run. Will the economy try to go back to original potential output level by shifting AS curve to right or stay at the new lower potential output level?

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Answer #1

The economy will stay at the new potential output with the increased inflation. The permanent shock will shift the long run aggregate supply curve to the left and the short run aggregate supply curve upwards finally the economy will reach at a lower output with an increased inflation, and that is the rise in the prices. This is shown by the graph below, it is not the aggregate supply curve that will shift, it would be the aggregate demand curve. The government may introduce an expansionary fiscal or moonetary policy in the economy. But that will not be effective

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