Question

a. c. Consider a typical aggregate demand and supply curve of an economy operating at its long-run equilibrium. Express the condition for long-run equilibrium and graphically show the long- run equilibrium of this economy in an AD-AS diagram. b. Explain and graphically show how a positive AD shock affects the short-run equilibrium of this economy. How do the price level and rGDP change in the short term as a result? Does the positive AD shock result in a recessionary gap or an inflationary gap? Explain and clearly indicate the size of the gap. d. What does this short-term output gap imply in terms of the rate of usage of factors of production compared to the normal rate indicated by potential output: higher rate of usage or lower than the normal rate? How does rate of usage of factors of production you indicate in part (d) impact the price of factors of production? f. What does the impact you identify in part (e) imply in terms of the unit cost of production for firms? What does the impact you identify in part (f) imply in terms of the profits of firms if the price of their product, quantity of production, and amount of factors of production they use for production remain constant? h. To remain as profitable as before, firms should increase their price at all levels of production level in response to the impact on their unit-cost of production that you identified in part (f). What does it mean in terms of the position of the aggregate supply curve? e.

Answer 1

a). Macro economy long run equilibrium through AD-AS is a condition where under wage - price flexibility the economy reach in a situation where SRAS(short run aggregate supply) , AD(aggregate demand) and LRAS(long run aggregate supply) intersect each other. It means here we have full utilisation of resources and real GDP is equal to potential GDP. The unemployment of the economy is at it's natural level. The equilibrium condition in the economy in AD-AS diagram can be shown by following figure -

Price level LRAS SRAS, P, 테 AD > 0 Y. Real GDP

In the above figure LR equilibrium is a situation where LRAS, SRAS, and AD intersect each other (point E1 in the figure). As SRAS and AD intersect it shows short run equilibrium and as LRAS also intersect so it shows LR equilibrium at the same time. At equilibrium potential GDP = Real GDP =Y_{​​​​1} and equilibrium price level is P_{​​​​​​1} .

(b). If an economy face positive AD shock then AD will shift rightward and due to shift of this AD we will get new aggregate demand say (AD2) in the figure. We will reach new short run equilibrium where AD2 and SRAS1 intersect each other. Let us consider the following figure to show this.

Price level LRAS SRAS, P2 E2 ap 테 AD ADV 0 Y, Y Real goP

In the above figure due to positive demand shock AD curve shifted from AD1 to AD2. We will have new short run equilibrium equilibrium where AD2 and SRAS1 intersect each other and this has been shown by E2 in the figure. In the new short run equilibrium real GDP in short has increased to Y2 and price level has raised to P2. In the new short run equilibrium real GDP will rise to Y2 and price level rises to P2.

(c). Due to this positive demand there will be inflationary gap. Because if short run real GDP is greater than potential GDP then this gap between real GDP and potential GDP is called inflationary gap. This inflationary gap arises if SR real GDP is more than the potential GDP. In the figure difference between Y1 and Y2 is the size of inflationary gap. This inflationary gap has been shown below.

Price level ERAS SRAS, P2 IP - E 7 AD2 AD 0 Real goP Inflationary gap.

In the above figure inflationary gap is the difference between short run real GDP Y2 and long run potential GDP Y1. This Y1-Y2 is the size of the inflationary gap. This is also called short run output gap.

(d). Due to this short run output gap factors of production will be used at more higher rate compare to the potential output level. Because at the potential output the economy is already in full employment and after this level of output increase implies the factors of production will be used at higher rate. Here factors of production will be used at higher rate compare to the normal rate.

(e). Due to higher rate of use of factors of production the price of factors will rise because there will be higher rate of use because of higher demand. This higher rate of use of factors of production implies rise in price of factors of production.

(f). As price of factors of production rises due to higher use of factors of production the per unit cost of production will rise and as a result firm will face higher per unit cost of production due to higher rate of use of factors of production.

(g). In this situation if price of output remains constant and amount of output they produce also constant along with amount of factors of production they use then profit of the firm will decrease because firm has to pay higher price for its factors of production.

(h). To maintain as profitable as before the firm has to raise it's price at all levels of production to counter the per unit increase in cost of production. Firm has to raise it's price of output at all levels to counter the situation of increase in per unit cost of production. The shift of SRAS curve will be leftward because higher nominal wage push the cost of production up and this will ultimately push aggregate supply to shift leftward so that it will reach its potential level but at higher price.