Question

Suppose that a sudden increase in aggregate demand moves the economy from its long-run equilibrium. (a) Illustrate this change using the aggregate demand-aggregate supply model. (b) What are the effects of this change in the short run and the long run?

Answer 1

A sudden increase in aggregate demand from its long run equilibrium which is when output equals full employment level of output shifts to a higher output in the short run as in the long run the economy cannot exist at a output above full employment level except if there is a structural change and equilibrium output only changes. Otherwise, an increase in aggregate demand would lead to inflationary pressures as price levels rise. In the long run, firms would shorten production to discourage excess demand as output is already above potential level so more production is not possible.