Answer to Question #82254 in Macroeconomics for Marija Borcic

Question

under a free market in which the self-adjusting mechanism operates efficiently aggregate demand shocks generate real effects in the short and long run, why is this false

Answer 1

Note that the shocks of aggregate demand can be caused either by a sharp reduction in money in circulation, or a reduction in aggregate expenditure.

In the free market, the negative effects caused by the shocks of aggregate demand will affect the inventory of firms because of the inability to implement them, which in turn in the short term will cause the reduction of production and reduction of workers. Under these conditions, a recessionary gap occurs, i.e. real GDP less potential. Producers will begin to reduce prices for products and this will lead to deflation and the economy getting to the point of long-term equilibrium.

It is necessary to emphasize that all of the above is possible only in a free market (in free competition). In real life, this is almost impossible because the state regulates the level of wages and firms cannot set wages below this level