Question

Question 1)

Suppose the economy is operating at both short-run and long-run equilibrium. Suppose consumers’ wealth increases, and they begin spending more on Tide Pod laundry detergent for entertainment purposes. Draw the graphs and shifts for the following questions and provide the specific mechanisms and channels.

a) What happens in the short run to both the aggregate price level and aggregate output when this shock occurs?

b) What will happen in the long run to both aggregate price level and aggregate output, as the economy adjusts, and what is the specific mechanism?

c) Is this an example of demand-pull inflation or cost-push inflation?

Answer 1

a) IN the short run this shock will shift the aggregate demand curve to the right and the new equilibrium will be at a higher price and higher output in the market.

SRAS1 SRAS LRAS Price KE1 AD2 Inflationary Gap AD1 Q* Q1 Output An increase in the demand will shift the aggregate demand curve to the right and cause inflationary pressure..

b) IN the long run , as the real wages have declined in the short run at the equilibrium level of E2, the wages will increase and that will act as a negative supply shock in the market shifting the supply curve to the left, the new equilibrium will be at price P2 and output back at the potential GDP that is Q*. The new equilibrium will be at E3.

c) This will be demand pull inflation as this is caused by an increase in the demand in the market.