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6. Using AD-AS model, please draw a diagram showing economy operating under its potential capacity. Describe...

6. Using AD-AS model, please draw a diagram showing economy operating under its potential capacity. Describe two ways how economy could have gotten there.

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This is situation is described as recessionary gap in which the economy produces less than its potential level. In the diagram we can see that the actual production takes place to the left of the LRAS, at E. Output Y* is less than potential output Yf.

One of the reason can be deficient demand which can be the result of increased taxes or decreased government spending. Another reason can be business pessimism where economic outlook for future is not very optimistic. Hence investment has done down which has shifted AD to the left. resulted in lower GDP

Price level LRAS AS Recessionary gap equal to (Yf - Y*) AD Y* Yf Real GDP

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