Question

Suppose an economy is producing at the optimal point in the AD/AS model. The government decides to subsidize college heavily, leading to a decrease in tuition by over half. In the long run what happens to the economy? Draw a graph and explain in words.

Answer 1

Starting from the point were the economy is at the potential level that is at A. the price is at P' and the output is at Y*, a decrease in the college fee will increase the disposable income in the hand of the people and they will demand more. that will shift the aggregate demand curve Ad to AD1. The new price in the market is at P* and the quantity output is at Y. Here the real wages are low as the market is operating at the inflationary point.

that will lead to a higher wage and acting as a negative supply shock the supply curve will shift to the left and the new curve will be SRAS1. the equilibrium in the market will be at B.the price is higher and the output will remain the same.