Answer to Question #113276 in Macroeconomics for aysu

Question

Think about an economy initially on its long run equilibrium. Assume that
autonomous consumption spending decreases. Explain how this economy will
go back to its long run equilibrium using the AS-AD model.

Answer 1

Reduced government spending would mean the reduced supply of money into the economy, unemployment, and low income resulting in a negative shock on the aggregate demand curve. The AD will first shift to the left from 1 to 2 in the short run resulting in reduced GDP at the stable prices but the economy will find its way back to the 3 by a gradual movement along the AD’ curve. This is because nominal wage falls in response to the high unemployment rate. The ultimate effect is no long-run variation in GDP but there are permanent lower price levels.

The economy can regain its self through fiscal policies that increase income to people such as increased government expenditure and reduced income taxation.