Answer to Question #226594 in Macroeconomics for Mariam

Question

Suppose that an unanticipated shock has hit the economy, causing the price level to be higher than its equilibrium level in the goods market. Assume that the interest rate is higher than its equilibrium level. With the use of diagrams, explain in your own words the effects of the unanticipated shock on the price level and output, assuming that fiscal policy is used to stabilize the economy. 

Answer 1

When price level increases beyond equilibrium level, aggregate demand will be cut down thus the output will also be reduced and the level of unemployment will rise.

When interest rate is higher than its equilibrium level, the level of investment falls because disposable income will be less and this will result in low savings.

In order to stabilize the economy, employment of fiscal policy will enable generation of additional demand when output is weak as shown by the diagram below, which employs the expansionary policy to increase demand and also output. Increase in demand is noted by the shift in aggregate demand curve to the right.