Question

The figure below depicts the aggregate demand curve (AD) and the long-run aggregate supply curve (LRAS) for the United States. The economy is initially at long-run equilibrium, at point A.

The figure below depicts the aggregate demand curve (AD) and the long-run aggregate supply curve (LRAS) for the United States. The economy is initially at long-run equilibrium, at point A.

One of the most contentious issues among economists involves the economy’s adjustment to long-run equilibrium. Some economists believe that adjustment can and should occur naturally. This group, the classical economists, stresses the importance of aggregate supply. Others see the return to long-run equilibrium as an adjustment that occurs unpredictably and often with much delay. This group, the Keynesian economists, stresses the importance of aggregate demand and calls for the government to speed the process back to full employment.

One tenet of classical economics is the assumption that prices are flexible throughout the economy. If prices are completely flexible, then the economy is essentially self-correcting: no matter what factors change in the economy, no matter what curves shift, the economy automatically comes back to full-employment GDP.

Suppose the economy now faces a recession caused by a collapse of the stock market that is also matched by a fall in expected future income. This situation would be represented by a shift of the AD curve to the left, due to a significant drop in consumption expenditure. AD2 is the new AD curve that depicts the fall in consumption expenditure.

According to classical economics, the economy will self-correct and recover from the recession on its own without government intervention. Use the figure below to depict the self-correction of the economy following the leftward shift of the AD curve. Note that this question is specifically asking you to evaluate this scenario as a classical economist. Therefore, you must determine whether you need to drag the curves or whether you need to use the point tool to mark the new equilibrium without shifting any curves.

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I tried shifting AD3 to the left, but was incorrect 

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As per classical economics, there is only one aggregate supply curve and that is valid for both short-run and long-run. The aggregate supply curve is vertical. Aggregate supply curve Initial price level New price level AD \ New AD Q* Real GDP A leftward shift in the aggregate demand curve will cause only the price level to change and the output level will remain the same. Initially, the equilibrium is A. The prices are flexible. When the AD curve shifts left, the price level falls enough to keep the output level constant. The new equilibrium is B.

answered by: Frank
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