Question

If the economy begins at a short-run equilibrium above potential output, then we would expect wage adjustment and price expectations change to?

Answer 1

If the economy begins at a short run equilibrium, when there is a positive output gap, that is, actual output is more than potential output, economy cannot sustain this output in the long run. This would lead to inflationary pressures in the economy as the demand is more than potential output, which is produced at the full employment level. In such a situation prices rise, wages rise, leading to decline in the output and finally in the long run economy reaches the potential outptu level. In the long run, hence, Output is equal to potential output and prices, wages rise. Higher wages push the labour supply upwards and higher prices push the output demand downwards thus bringing the economy in the long run equilibrium.