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Consider the closed-economy model.Suppose the economy is then hit by an adverse supply shock, which causes...

Consider the closed-economy model.Suppose the economy is then hit by an adverse supply shock, which causes P1 to jump up to P2 > P1. Using Keynesian cross and money market diagrams, explain what will happen to the IS and LM curves in the short run as a result of this shock.  Use IS-LM and AD-AS diagrams to show what happens to the economy in the short-run, long-run, and during the transition, following the supply shock.

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Due to adverse supply shocks the price will rise from P1 to P2. This rise in price will lower down the output from Y0 to Y1. The increase in price lowers down the real money supply (M/P). Hence the LM curve shifts leftwards. This shift in LM disturbs the equilibrium level of interest rate. The rate of interest increase from r0 to r1. In short run, the economy is facing with an increase in price that is there is inflation, with the decrease in output and with a high rate of interest. Due to increase in price rate, the real wage will too fall in long run. The decrease in output will increase the unemployment rate. So in long run, the economy will be facing with reduced real wage and increased unemployment.

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