Question

1. Consider an economy that is in the short-run equilibrium, above the level of the tructural output. i) What kind of shock could have caused this expansion in the production? Discuss the economic adjustments using the aggregate supply and demand model (OA-DA). (ii) In the absence of other exogenous shocks, explain how the economy would return to its level of structural equilibrium.

Answer 1

i) In the figure provided, the economy is in short run equilibrium and there is an positive output gap because the level of GDP is greater than the structural GDP (Potential).

Assume that previously the economy had an output level equal to its structural level so that AD, SRAS and LRAS all are equal to each other. Then, a positive aggregate demand shock occurs which shifts the AD curve to the right. This raises the level of output beyond the structural level and increases the price level as well. Positive output gap can also result when AS shifts right

Pricą LRAS SRAS P1 Pf AD2 AD1 Real GDP Yf Y1

ii) As the price level has risen, with unchanged nominal wages, firms face falling profit and so they start producing less. This reduces production and decreases aggregate supply. Hence AS shifts to the left and GDP level falls. This raises the price as well. But GDP returns to its structural level.

Price level LRAS SRAS Pf AD1 AD YF Y* Real GDP