Question

Starting from long-run equilibrium, use the basic aggregate demand and aggregate supply diagram to show what happens in both the long run and the short run when there is an increase in wealth. (10 points)

Answer 1

An increase in the wealth in the short run will shift the aggregate demand curve to the right , the new equilibrium will be at higher price and higher output. At this point the economy is facing a inflationary gap and the real wages in the economy is low. In the long run, the wages will increase and the supplier will face a negative supply shock,it will shift the supply curve to the left and the new equilibrium will be at the potential level and price will be higher.