Question

ECO - 252 -- Macroeconomics

6. Imagine that in 2015 the economy is in long-run equilibrium. Firms suddenly become pessimistic about the future. Using the AD-AS model and assuming policymakers take no action,

a. Which curve shifts and in which direction?

b. In the short run, what happens to the price level and real GDP?

c. What happens to the expected price level?

d. What will happen to nominal wages?

e. In the long run, what will happen to the short-run aggregate supply?

f. What happens to the price level and real GDP in the long run (i.e. compare that new equilibrium to the

initial equilibrium)?

Answer 1

a) Business pessimism will result in lower investment so that AD shifts inwardds

b) In the short run assuming positively sloped AS, this will reduce Price and GDP both

c) Expected price level will fall when AD shifts inwards as actual price level has fallen

d)) Nominal wages are sticky so they do not change in short run but the same will fall in future as price level has fallen

e) In the long run AS will shift rightwards because firms will pay lower nominal wage so they hire more and produce more

f) Compared to original equilibrium at E, price level has fallen further but GDP returns to its original level. (New equilibrium is G)