Question

Use AD-AS model show effects of negative demand shock and explain how the classic economic theory will do about it.

Answer 1

AD -AS model for a negative demand shock

Suppose the economy is initially in equilibrium at P1 and Q1. Q1 represents the natural level of output i.e the level of output when the resources are fully employed. A negative demand shock such as fall in consumer confidence causes AD curve to shift left to AD2. It causes prices to fall to P2, which results in lower production and finally fall in real output to Y2

According to classical theory, shocks are short term phenomena with short term effects. Classical economics puts faith in long run self adjustment capability of an economy. The self correcting nature will enable the economy to return to natural level of output, Y1.

In other words, classical economics would leave the economy alone to correct itself. It will not employ policy intervention.

In the case of a demand shock, fall in prices and output is reversed when the SRAS curve shifts right. At Y2, the economy is below its potential i.e unemployed resources exist. The classical theory predicts that when unemployed resources exist, the wages would decrease (wage flexibility). Decrease in wages enable the suppliers to increase production. So, short run aggregate supply increases from SRAS1 to SRAS2. This brings the economy back to the natural level of output (Y1). Thus in the long run, the economy would always be at natural level of output represented by LRAS

SRAS, LRAS SRAS TADI, 02.