Question

When the economy is in a short-run equilibrium, with output greater than potential GDP, the short-run aggregate supply curve will shift to the left. Why would this happen?

1. With output above potential GDP, the economy produces too many goods and those goods are sold at prices that are too high.
2. This happens only after government interference.
3. With output above potential GDP, wages will be bid up and the expected price level will rise from the increase in the actual price level.
4. With output above potential GDP, the economy does not produce enough goods and those goods are sold at prices that are too high.

Answer 1

With output above potential GDP, wages will be bid up and the expected price level will rise from the increase in the actual price level.

this happens because inflationary gap increases the price level beyond the expected price level. In the short run people are not able to revise their estimates but when in the long run they expect a higher price level especially producers, the increase the nominal wage in order to maintain the real wage rate. Higher nominal wages will increase cost of production and decrease total production which shifts the aggregate supply curve to the left