Answer to Question #115266 in Macroeconomics for Liu Ka Yee

Question

Suppose the economy is currently having an inflation expectation which equals to actual inflation.
Explain how the output level will be affected in the short-run and long-run if there is a demand shock that
drives the actual inflation to fall below expectation.

Answer 1

Effect of Long run on Inflation

The long run is the period when the general price level, contractual wage rates, and expectations adjust fully to the state of the economy.

The output level of a long run firm will not be affected by inflation because all factors of production and costs are variable i.e firms in the long run will be able to adjust all costs fully to the state of economy.

A firm may implement change by increasing (or decreasing) the scale of production in response to profits (or losses), which may entail building a new plant or adding a production line.

Effect of Short run on Inflation

Short run occur when firms are only able to influence prices through adjustments made to production levels. These variables may not fully adjust.

Inflation in a short run firm always affect economic profits, because all factors of production are fixed, except for labor, which remains variable. And inflation leads to increase in wages and increase in price of commodities. A short run firm will likely to experience loss due to inflation.