Suppose that an economy initially at full-employment is hit by an adverse supply

Question

Suppose that an economy initially at full-employment is hit by an adverse supply shock

a)    What will happen to output and the price level in the short run?

b)    What will happen to output and the price level in the long run?

c)    If left to its own devices, the economy will follow an adjustment process very similar to the one you described in part (c) of the last question. Suppose, however, that the government intervenes. Show, using an AS-AD graph, how the government can use accommodating monetary or fiscal policy to return output and unemployment to their long-run values.

Explanation / Answer

a) In short run the output does not change, however the price level increases to restore equilibrium.

b) In long run, Ourtpu decreases and Price level increases.

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