Consider the diagram below, which is drawn under the assumption that the new Keynesian sticky-price theory of

Question:

Consider the diagram below, which is drawn under the assumption that the new Keynesian sticky-price theory of aggregate supply applies. Assume that at present, the economy is in long-run equilibrium at point A. Answer the following questions.

a. Suppose that there is a sudden increase in desired investment expenditures. Which of the alternative aggregate demand curves-AD2 or AD3-will apply after this event occurs? Other things being equal, what will happen to the equilibrium price level and to equilibrium real GDP in the short run? Explain.

b. Other things being equal, after the event and adjustments discussed in part (a) have taken place, what will happen to the equilibrium price level and to equilibrium real GDP in the long run? Explain.