Question

Layout the classical view of what will occur when SRAS intersects with AD at a point beyond LRAS (an "overheated economy").

Answer 1

If the economy is experiencing an inflationary gap i.e. an overheated economy, the demand will be higher than the supply of goods. An increase in the price due to higher demand will decrease the real wages of the employees in the economy, They will demand a higher wage and at a higher wage the input cost of production will increase.

At a higher cost of output, the price in the economy will rise further and demand will fall, this will continue to the level where the demand is again at the potential level i.e.at LRAS.

the wages nominally will be higher, the price will be higher but the real wage and price will remain at the actual level as the classical economy faces money dichotomy.