Question

7. [ 15 ] Suppose that the economy experiences a negative inflation shock, show this on AD/AS curves in both the long and short run?

Answer 1

A negative inflation shock occurs when aggregate demand decreases, reducing both price level and real GDP.

This situation arises from decrease in aggregate demand, shifting AD curve leftward, decreasing both price level and real GDP in short run.

In the long run, lower price level will decrease prices of inputs, raising production costs. Firms will increase production, increasing aggregate supply. SRAS shifts rightward, intersecting new AD curve at further lower price level but restoring real GDP to potential GDP.

In following graph, AD0, LRAS0 and SRAS0 are initial aggregate demand, long-run aggregate supply and short-run aggregate supply curves intersecting at point A with initial price level P0 and real GDP (potential GDP) Y0. When negative inflation shock exists, it means that AD0 has shifted left to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1 in short run, so recessionary gap is (Y0 - Y1).

In long run, SRAS0 shifts right to SRAS1, intersecting AD1 at point C with further lower price level P2 and restoring real GDP to potential GDP level Y0.

LRASO SRAS. SRAS, Y Yo