Question

Using the aggregate supply and demand model, illustrate what happens in the long run when the economy suffers a supply shock. Begin your analysis by assuming the economy has suffered the supply shock in the short run, but has not yet adjusted to it in the long run. (10 points)

Answer 1

• When supply shocks occur, the aggregate supply curve shift to left thereby causing rise in price level and fall in employments and output.
• Further, over the long run, the supply curve shifts to right again the establish equilibrium level where full potential is utilized.

Following is diagram:

In above diagram, Supply curve AS1 shift to AS2 when supply shock hit economy in short run but over the long the long run, supply curve again moves or shifts to right thereby causing rise in real output level.