Suppose initially the economy is at point A What happened ne

Suppose initially the economy is at point A. What happened next in this economy? What events could have caused these changes?

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

Solution

The economy begins with long-run equilibrium point A, when aggregate demand unexpectedly increases from AD1 to AD2. The price level rises from P1 to P2. But people can not change their expectation in the short run. So expected price is still at P1. As P2 is above their expectation, output rises(GDP2) temporarily above the natural rate, as the economy moves along SRAS1from point A to B., In the long run, the expected price level rises to P3, causing the SRAS1 shifts to SRAS2. The economy returns to new long-run equilibrium point C, where the output is back at is the natural rate(GDP1).