Question

Starting from long-run equilibrium, draw an aggregate demand-aggregate supply graph to illustrate the difference between a long-run and a short-run equilibrium due to an increase in aggregate demand. Once the economy is in the short-run equilibrium, explain and graphically illustrate how long-run equilibrium will be restored.

Answer 1

The long-run equilibrium is at E. Aggregate demand is AD1 and aggregate supply is SRAS1. Now at F, AD has increased which implies that short run equilibrium due to increased aggregate demand is at F. The difference between a long-run and a short-run equilibrium due to an increase in aggregate demand can be seen below where now the price level is higher at P1 and real GDP is also higher.

From this short run equilibrium to the long run equilibrium at G, the short run aggregate supply curve will shift to the left to SRAS2. This is because long run has nominal wages adjusting for prices and thus production is reduced. This causes the price level to rise further to P2 but GDP is back to Yf.