7.

Consider a typical aggregate demand and supply curve of an economy operating at its

long

-

run equilibrium.

a.

Express the condition for long

-

run

equilibrium

and g

raphically show the long

-

run equilibrium of this economy in an AD

-

AS diagram.

b.

Explain and graphically show how a

positive AD shock

affects the short

-

run

equilibrium

of this economy. How do the price level and rGDP change in the

short term

as a result?

c.

Does the positive AD shock result in a recessionary gap or an inflationary gap?

Explain and clearly indicate the size of the gap.

d.

What does this short

-

term output gap imply in terms of the rate of usage of

factors of production compared to th

e normal rate indicated by potential output:

higher rate of usage or lower than the normal rate?

e.

How does rate of usage of factors of production you indicate in part (d) impact

the price of factors of production?

f.

What does the impact you identify in part (

e) imply in terms of the unit cost of

production for firms?

g.

What does the impact you identify in part (f) imply in terms of the profits of

firms if the price of their product, quantity of production, and amount of factors

of production they use for product

ion remain constant?

h.

To remain as profitable as before, firms should increase their price at all levels

of production level in response to the impact on their unit

-

cost of production

Page

4

of

5

that you identified in part (f). What does it mean in terms of the posit

ion of the

aggregate supply curve?

i.

Now that you know all the steps, e

xplain the

whole

process of transition to a

new long

-

run equilibrium after the same

positive

demand

shock in (b). Clearly

indicate the reason why the AS curve shifts, if it does at all.

(You should be able to analyse all these steps for a negative AD shock, positive

AS shock, and negative AS shock as well.

The positive or negative AD shocks

could be due to implementation of government fiscal policies.

If you find

answering this question

difficult, see

chapter 24 (figures

and the associated

explanations

) in the

textbook.

You should also be able to compare the

composition of long

-

run equilibrium output between the initial long

-

run

equilibrium and the new long

-

run equilibrium. See, e.g., the

same chapter

under Fiscal Policy and Growth.

)