Question

Suppose the aggregate demand and the short-run aggregate supply of a country INCREASES.

a) Starting from a long-run equilibrium, use an AD-AS diagram illustrate the effects of these two changes. Label the initial long-run equilibrium as point A and the resulting short-run equilibrium as point B.

b) Suppose policymakers adopt contractionary macroeconomic policies to restore the long run equilibrium. On the same diagram from part a, show the resulting impact on AD or AS curve and label the new long-run equilibrium as point C.

Answer 1

a) Increase in aggregate demand shifts the AD curve rightwards to AD2, while the increase in aggregate supply shifts the AS curve to AS2. The short run equilibrium is at B, where the output is more than the full employment level. There is inflationary pressure in the economy.

b) Using a contractionary monetary and fiscal policy the economy can reach at it's long run equilibrium at C. A contractionary monetary or fiscal policy shifts the AD curve leftward to AD3. The equilibrium is at C where economy is back to full employment output level but the prices are lower.