1. Problems and Applications Q1 Suppose the economy is in a long-run equilibrium
ID: 1116559 • Letter: 1
Question
1. Problems and Applications Q1 Suppose the economy is in a long-run equilibrium, as shown in the following graph. Now suppose that firms become pessimistic about future business conditions and decide to cut back on investment spending, resulting in a fall in aggregate demand. Use your diagram to show what happens to output and the price level in the short run. LRAS Aggregate Supply Aggregate Demand Aggregate Supply LRAS Aggregate Demand Quantity of Output As a result of this change, the unemployment rate Use the sticky-wage theory of aggregate supply to think about what will happen to output and the price level in the long run (assuming there is no change in policy) On the graph, illustrate the change that will occur in the long un.Explanation / Answer
As mentioned in the question itself the aggregate demand will shift to the left and this will reduce the price level as well as the output in the short run. Because the output is reduced firms have wired many employees so that unemployment rate has increased.
According to the sticky wage theory wages will not change in the short run. This implies that the real wage will rise. Workers will supply more labour and therefore there will be a rightward shift of the short-run aggregate supply curve. This will ensure that the economy in the long run achieves its full employment level of output. However the prices will further reduce.
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