Question

Assume that Australia’s macroeconomic equilibrium is equal to potential GDP. What would happen if the demand for new houses increases? Using the 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

Assuming that the Australian economy is initially in long run equilibrium, then if the demand for new houses increases then this will mean that consumption and investment increases. This will cause the aggregate demand curve to shift rightwards and so this causes the prices and the output level to increase.The economy moves beyond full employment. The price level increases and the economy moves to B as the AD curve shifts rightwards. In the long run the economy adjusts back to the long run equilibrium but at a higher level of prices at C. So the output level returns to the potential level but prices increase permanently.