Question

b) Assume that Australia’s macroeconomic equilibrium is equal to the potential GDP. What would happen if the demand for new houses increases in Australia? Using AD-AS model, explain carefully the immediate and long term effects of the event towards the economy. Draw by hand the appropriate AD-AS diagram to support your explanation.

Answer 1

Australia’s macroeconomic equilibrium is equal to the potential GDP. This case is shown below where LRAS = SRAS = AD all are equal to each other at E

Now the demand for new houses increases in Australia. This implies that there will be residential investment so AD will shift to the right, creating an inflationary gap initially. This shifts causes prices to rise and output to increase in the short run

In the long run higher price level would result in reducing real wage so nominal wages are revised upwards to match the price increase and this implies firms demand fewer labor. Supply is reduced and so AS shifts to the left. Long run equilibrium at G has the economy shifted back to its potential GDP of Yf but the price level has increased further