Question

A. To start this process, explain and show in an AD/AS graph how the economy returns to the long-run, full-employment equilibrium level of output from the following levels:

Answer 1

@whpalmer4 there are 3 parts to this:

I. A level of output that is higher than the full-employment level

II. A level of output that is lower than the full employment level

III. Are prices rigid or flexible in your answers to I and II?

Answer 2

I. When levels of GDP are higher than full employment, then the economy is in a boom phase. The current output the economy is producing is far greater than resources available can, so pressures escalate in the factor markets as producers compete for limited productive inputs, this drives up the inflation rate, and creates an expansionary gap. Government and Reserve bank contractionary policy will be able to put back demand to Yfe, and naturally overtime the prices of wages will fall and other resources, like when the inflation and interest rates take full toll on consumer and producers spending patterns,slowing them down.

Answer 3

II. When the level of GDP is less than full employment level, that is equilibrium, where the SRAS and AD curves intersect are to the left of the LRAS curve. Here the economy experiences an output gap as it is in a trough. The economy has excess capacity, and resources like labour are being wasted. Previously employed workers aren't taking part in the workplace of firms where they may have allowed it to work efficiently, and contributed to more goods and services being produced, to reach full employment level. And this leads to high cyclical unemployment. Here inflation isn't much an issue. To get back to higher levels of economic activity, so that firms invest and can replenish capacity to produce stocks to satisfy growing demand, the government must implement expansionary policy as well as the RB, but monetary. The level of aggregate supply may also increase itself naturally because eventually with time demand for resources by firms to householders for resources will fall so that current supply equals to what potentially is able to be produced by the economy.

Answer 4

III. Prices are flexible.