Tutorial Excercises Solutions
Question 4) Suppose an economy is in the long-run equilibrium
a) Use the model of aggregate demand and aggregate supply to illustrate the initial equilibrium (call
it point A). Be sure to include both short run and long run aggregate supply
Answer
AS0
price
LR AS
A
AD0
Potential GDP
Full Employment Equilibrium
b. Assume that there is a negative supply shock (oil prices increase). What happens to the
aggregate supply curve? Explain
price
Answer: An increase in the oil prices will increase production cost. This will decrease short run AS.
(Negative supply shock) AS will shift to the left (AS0 to AS1). The economy reaches equilibrium at B.
which is below Full employment (recessionary gap).
LR AS
AS1
B
A
AD0
Actual
RGDP
Pot. GDP
Full Emp. Eq.
AS0
c) Use your diagram to show that happens to output and the price level when the economy moves
from the initial to the new short run equilibrium (call it point B)
Answer: In short run equilibrium move from point A to B. Real GDP (Aggregate output) will
decrease and unemployment rate will increase (Recessionary gap).
d) Now show the new long run equilibrium (call it point C). What causes the economy to move
from point B to point C? Explain.
Answer: In the long run if no action is taken, because output decreases demand for labor also
decreases. When demand for labor decreases without a change in supply of labor than wages will
decreases. This will decrease cost of production then short run AS will increase (shift to the
right; from AS1 back to AS0) to the original full employment position (point A).
If policy actions are taken (for example expansionary fiscal policy; lower tax rate or increase G,
or monetary policy; increase Money supply) AD will shift to the right (AD0 to AD1) and
economy returns to the full employment at a higher price level (from point A to C).
price
LR AS
AS1
C
B
A
AD0
Pot. GDP
Full Emp. Eg.
AD1
AS0
Question 5. Suppose an economy is in long-run equilibrium.
a) Use the model of aggregate demand and aggregate supply to illustrate the initial equilibrium
(call it point A). Be sure to include both short run and long run aggregate supply.
Answer
price
LR AS
A
AD0
Pot GDP
Full Emp. Eg.
b) If the Central Bank increases the money supply. What happens to the aggregate demand
curve? Explain.
Answer: Increase in money supply shifts AD to the right (AD0 to AD1). Increase in Ms--- i rate
will decrease ---- C and I will increase ---- AD will increase (shit to the right to AD1).
price
LR AS
A
AS0
B
AD0
Pot. GDP
Full Emp.Eq.
AD1
c) What happens to the level of output and the price level in the short run? Use your diagram to
illustrate how the economy moves from the initial to the new short-run equilibrium (Point B)
Answer: In the short run economy move from point A to point B and it has rising in output and
price level (Inflationary gap).
d) What happens to the level of output and price level in the long run? What causes the economy
move from point B to point C (long run equilibrium?)
Answer: In the long run wage adjustment (increase due to the increase in price level) decrease
short run AS; shifts AS to the left (AS0 to AS1). It cause increasing in price level but reducing
real output until the economy returns to the initial level of output (from point A to C).
LR AS
AS1
price
C
B
A
AD0
Pot. GDP
Full Emp. Eq.
AD1
AS0