Q. Consider a self-regulating economy is in long run equilibrium (no recessionary and inflationary gap) and suddenly there is a decrease in the aggregate demand for a decrease in investment. With the help of a diagram, explain how in the short run the AD curve shift results in recessionary gap and eventually how the self -regulating economy brings the economy back to the long-run equilibrium. Also state what happens to the price level and real GDP in the short run and long run.
Hint: First draw the diagram, the confusing part is that in the diagram we have everything together, but you have to explain it in a sequence.
Ans: The economy is initially in the long run equilibrium at point 1. A decrease in investment for a given price level will shift the aggregate demand to the left (from AD1 to AD2). As a result the economy will be in a recessionary gap in the short run at point 2 where both the real GDP and price level is less than it was at point 1. In a recessionary gap, we have surplus of labour and unemployment rate is greater than the natural rate of unemployment, which will induce in the self-regulating economy to form new contracts with lower wage. This will result in the shift of the short run supply curve to the right (from SRAS1 to SRAS2) for increase in overall supply which restores the long-run equilibrium at point 3 at a lower price level p3.
Hint: if you are having difficulty with drawing the diagram, draw it step by step, first draw a AD line, a LRAS line and a SRAS line. Then draw the new AD line (AD2) to the left of the first AD line to get the recessionary gap, and then finally draw the new SRAS line (SRAS2) to restore the long run equilibrium.
Hint: whenever there is long run equilibrium, any change in aggregate demand will eventually cause both the AD and SRAS lines to shift. But if we can start with only a recessionary gap or an inflationary gap, we will have only shift in the SRAS line.
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