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 initial shift would be the aggregate demand curve from AD1 to AD2. This is because of the rise in the aggregate demand in the economy, the rise in the aggreagte demand can be due to various reasons such as the increase in the government expenditure, decrease in the taxes, increase in the money supply and etc...

When there is increase in the government expenditure it adds more money into the economy so the income of the people will rise and they consume and invest so the aggregate demand will rise. If there is decrease in the taxes it would increase the disposable income of the people and this induces the people to consume more and the aggregate demand rises.

When the aggregate demand shifts to the right it has resulted in a higher price level and increase in the aggregate output. When the prices increases the real wages of the labours will decrease and in the short run they dont get this. But in the long the workers will recogonize this and will ask for a rise in their wages. So the rise in the wages adds to the cost of production of the firms so this increases the costs to the firm and the result is the firms cut back their production so now the short run aggregate supply curve would shift to the left. So at first the economy moves from A to B and then B to C.

So ultimately the rise in the aggregate demand only results in a higher price level in the long run.