Question

We examined the Keynesian model in class. Using the AS/AD model, explain how the economy would recover from a recession.

Answer 1

Starting from point A, the price is P* and the output is Y which is less than the potential output at Y*. The nation is experiencing a deflationary gap. Here, the unemployment will be high and because of high unemployment the wages will fall and that will act as a positive supply shock, it will shift the aggregate supply curve to the right. Further decreasing the cost and increasing the demand.

The new equilibrium will be at B which is equal to the potential output at Y*.