Answer to Question #115029 in Macroeconomics for Sura Alnaimy

Question

Now assume that for some reason Aggregate Demand shifts to the left (downwards) and suppose wages fully adjust. By using the AS-AD graph, show the effects of this shift on the equilibrium output and price level in the Short-Run and in the Long-run.

Answer 1

Short-Run 

Keynesian model describes the economy in a short period and is based on the following premises: underemployment in the economy; commodity prices and nominal wages are tough.

Under these conditions, the aggregate supply curve is horizontal. Fluctuations in aggregate demand affect production, the price level does not change. For example, a decrease in money supply shifts AD 1 to position AD2. The economic equilibrium moves from point E1 to point E2. Production volume - from point Y1 to point Y2, declining

Long-run

Under these conditions, the AS curve is vertical. It characterizes the natural (potential) level of the volume of production, i.e., the volume of production under conditions of full employment, in which the resources of the economy are fully used, and unemployment is at a natural level. Fluctuations in aggregate demand are changing prices. For example, when the supply of money decreases, the curve AD1 shifts to the left to the position AD2. The economic equilibrium is shifting from point E1 to point E2, however, the quantity of production AS remains unchanged.