Question

Suppose the economy is starting from a situation of long-run equilibrium. In this case, we know that its equilibrium output (Y) is equal to greater than less than its potential output (Y'). Starting from its long-run equilibrium at point 1 in the figure to the right, suppose the economy experiences a positive demand shock. 1) Using the line drawing tool, shift a single curve to show the initial short-run effect. Properly label your curve. 2) Using the point drawing tool, identify the new short-run equilibrium. Label this point '2'. Carefully follow the instructions above, and only draw the required objects. In the short-run equilibrium at point 2, labor markets would likely see increasing slack OR tightness and corresponding stronger pressure on wages and costs that forces firms to raise their 7 prices OR profits at a more rapid rate. Graphically, this chain reaction produces shifts in the short-run aggregate supply curve that are V up and to the left OR down and to the right These shifts in the short-run aggregate supply curve result in output gaps that are V widening OR narrowing and the economy is evolving toward an eventual new long-run equilibrium with an inflation rate that is lower OR higher

Don't need answer to 1 and 2. NEED solution for rest of questions please.

Answer 1

At point 2, the actual output is higher than the potential output. Therefore, the unemployment is lower than the natural rate of employment.

Thus, the labour market is tight

(Tight means very low unemployment- demand high but supply of labour low)

Due to this, there would be an upward pressure on wages. As a result, firms will be forced to increase their prices

Higher wage costs would force producers to reduce production, therefore supply curve would shift inwards (to the left)

Therefore, the output gap narrows as actual output decreases to come in line with the potential output.

The new long run equilibrium would have higher inflation as the wages have increased, demand has increased.