Question

How does a positive production shock effect the

a) the demand and supply of labor

b) ISLM model

c) Aggregate demand

Answer 1

(a) A positive production shock increases output and production by firms, therefore firms hire more labor and increase their demand for labor. The demand for labor curve shifts rightward, and labor supply remaining unchanged, which increases both the wage rate and employment (lowering unemployment).

(b) As firms hire more and produce more, investment rises, leading to a rightward shift of the IS curve. The LM curve remaining unchanged, a rightward shift of IS curve increases interest rate and increases output.

(c) Higher output by firms increases the (short run) aggregate supply, which shifts the AS curve rightward. Aggregate demand remaining unchanged, the rightward shift in AS curve increases real GDP and decreases aggregate price level.