Q.8 (10 points) The diagram below represents the LRAS, SRAS and AD curves of a country. The Long-Run and Short-Run equilibrium is point E where the price level is P(1) and the output level is Y(1). Suppose that there is a shock that shifts the SRAS curve leftwards to SRAS' while the LRAS and the AD curves remain unchanged. P LRAS SRAS' SRAS P(1) AD Y(1) Y (a) A student tries to figure out the effect of the shock on the economy in the short-run by the following steps. Step 1 As the SRAS curve shifts leftwards, output decreases. Step 2 Hence, the income of the households drops Step 3 As the income of the households drops, their consumption will decrease. Step 4 As their consumption drops, the AD curve will shift to the left. Is the logic above correct in understanding the effect of the shock on the economy in the short-run ? If yes, specify where the Short-Run equilibrium will be relative to the initial equilibrium E. In particular, let Y(SR) and P(SR) be the output and price level in the short-run equilibrium. State if Y(SR) will be higher than, lower than or remain the same as Y(1). State if P(SR) will be higher than, lower than or remain the same as P(1). If no, state in which step the student starts to make error, explain why it is wrong, and then replace the steps with your own logic that explains the effect of the shock on the economy in the short-run. Also, let Y(SR) and P(SR) be the output and price level in the short-run equilibrium. Then based on your logic: state if Y(SR) will be higher than, lower than or remain the same as Y(1), and state if P(SR) will be higher than, lower than or remain the same as P(1). (b) Based on the short-run equilibrium you stated in part (a), if there is no intervention from the government or the Central Bank, which curve will shift and in what direction over time to bring the economy to the new long-run equilibrium? Let P(LR) and Y(LR) denote the price level and the output level in the new long-run equilibrium. State if Y(LR) will be higher than, lower than or remain the same as Y(1). State if P(LR) will be higher than, lower than or remain the same as P(1)