Question

Suppose an economy is hit by a recession and people's income fall. a)Show graphically using AD-AS model how the price level and output are affected in the long-run. b)Can the government use fiscal policy to offset the effects on price level and output,explain?

Answer 1

a)

Starting from the point A, here the income of the people are affected by fall in the income and output in the market is below full employment that will occur at LRAS. in the long run the SRAS will shift to SRAS2 and the new equilibrium point will be at B, this is at a lower price P2 and at the potential level of output.

b) If the government use a fiscal policy in the market then the demand curve will shift from D1 to D2 and the new equilibrium will be at a higher price and higher level of output. This will not force the SRAS to shift to the right.