LRAS Price level SRAS2 SRAS 3 2 AD2 AD GDP GDP Real GDP 2 So

LRAS Price level SRAS2 SRAS 3 2 AD2 AD GDP, GDP Real GDP 2

Solution

From point A the economy moved to point B . The aggregate demand curve shifter right . This increase in aggregate demand may be caused by increase in government expenditure or tax cuts or any other policy that causes money supply to rise . The AD curve shifts from AD1 to AD2 .

This causes an inflationary gap . The actual output is greater than potential output at point B . The price level rises to P2 . Hence , nominal wages increase in short run . Inflation causes rise in nominal wages also . So short run aggregate supply will decrease due to rise in wages . The SRAS shifts from SRAS1 to SRAS 2 . This helps to close the gap at point C .