Hey guys. Need some help with the following question:
QUESTION: In short-run equilibrium, if aggregate demand is increasing faster than long-run aggregate supply:
A. the price level is likely to increase. B. downward pressure on wages should ensue. C. supply will increase to meet the additional demand. ANSWER: (A) (A) If AD is increasing faster than LRAS, the economy is expanding faster than its fullemployment rate of output. This will cause pressure on wages and resource prices and lead to an increase in the price level. The SRAS curve will shift to the left-a decrease in supply for any given price level-until the rate of output growth slows to its fullemployment potential.
First of all, LRAS is a vertical line - so what is the notion of “AD increasing faster than LRAS”? I based my analysis on the figure below:
While in the long term the price does increase as seen at the intersection of AD1 and SRAS1 (at same original output), this question is asking about the short-run equilibrium. So, based on this figure above, the intersection of AD1 and SRAS0 is not the correct point? In which case, both (A) and © would be correct.
What am I missing? Thanks.
AD increase faster the LRAS means AD curve is shifting to the right (From what I hear, Economists are anal about this crap – they like to claim curves shift left/right instead of up/down – doesn’t matter for our purposes, but just throwing it out there).
This is something I didn’t like about L1 Econ… they tried to explain multiple things via one figure. In your picture, forget about SRAS1 in the short run. For almost all L1 Econ questions, they won’t ask you to analyze a phenomenon by altering multilple variables. So, you can’t have price and supply expanding while AD is also expanding. You assume price, supply etc. remain constant while AD expands, and then analyze the impact based only on the movement of the AD curve.
In the question, AD is growing at such a rate that it goes from AD0 to AD1. This puts upward pressure on price (AD curve shifts right). So you go from P0 to PSR. Remember, supply is still at SRAS0 becuase supply lags the expansion in AD in the short run. When prices increases, so do wages. So option B is wrong.
In the long-run SRAS will adjust such that it shifts from SRAS0 to SRAS1 (SRAS curve shifts left). This results in permanent increase in the price level as indicated by PLR. Since the question is asking about the short-run impact, option C is wrong because supply can’t adjust immediately. Think of the supply curve (with regards to this question) as being “sticky.”
Hope this helps.