Question

6. The graph below shows the current equilibrium in an economy (Y,: potential output). ASo ADo If autonomous consumption increases, (a) Show the SR and LR changes in the graph above. (b) What are the changes in output and price level from the current equilibrium to the new short-run equilibrium? (c) What are the changes in output and price level from the current equilibrium to the new long-run equilibrium?

Answer 1

a. ASo P- Pi Po e2 ADi ADo YF Yi In the figure, ei represents new short run rquilibrium where e2 represents new long run equilibrium. b. Increase in autonomous consumption will increase the aggregate demand and this will cause a shift in aggregate demand curve to the right. This is represented by new aggregate demand curve ADi. This ADi intersects the short run aggregate supply curve at point ez and this poin represents the new short run equilibrium point. New shortrun equilibrium output level is Yi and the equilibrium price level is Pi. That is, at new short run equilibrium output and price level will be higher compard to the intial equilibrium point c. New short run output level was higher than that of the potential output leval causing an inflationary gap in the economy In the long run, economy will attain a new equilibrium at point ez. Corresponding equilibrium output will be the potential output level, Yp And the new long run equilibrium price will be P2 That, in the long run equilirium, output will be at the potential level where the price level will be much more higher compared to the short run equilibrium and initial equilibrium prices. |