Question

Explain, using a carefully labeled graph, how the economy adjusts under the AS/AD model that we covered in class when there is a cost-push shock.

Answer 1

When the Aggregate Supply decreases it is called as cost-push shock to the economy. With the decrease in aggregate supply the Short Run Aggregate Supply curve shifts to the left and with the aggregate demand remaining unchanged, the equilibrium price increases to the new equilibrium price P₁ from the initial equilibrium price P and the equilibrium output decreases from the initial equilibrium quantity Q to the new equilibrium quantity Q₁. So, the price increases and the quantity also decreases in the short run.