Question

Suppose the economy is initially in long-run equilibrium in the AD-AS model. Then stock prices decline sharply. Draw a diagram (show changes) of AD, LRAS, and SRAS for short run and long run with no government intervention.

Answer 1

When the economy is in long run equilibrium and stock prices falls. People who have invested their money in stock will face huge loss which will reduce their income and profit level. This will cause aggregate demand to fall which will shift the demand curve from AD to AD1 while SRAS remains the same. This will cause price level to fall from P* to P1 and output to fall from Y* to Y1. In long run, firms which faced huge losses would have inventories of their product. To clear the inventories, they will sell more of their products which will raise the aggregate supply and reduces the price further to P2 level and take the output level back to Y*. This will take the output back to its long run level with reduced price level.