Practice Problem 1: Suppose the economy is initially in its long-run equilibrium where the prices of factors of production have already adjusted and thus Y=Y*. Suddenly there is an economic shock, say because the nation's exports increase due to a trade agreement being signed with a neighbor country. The following graphs illustrate the adjustment of the nation's AD, AS, and AE curves after the shock, including the intermediate period in which wages and other input prices will adjust to bring the economy's Real GDP back to its potential level.
Task 1.1: Underline the correct option.
a) Before the increase in exports, the economy was in a macroeconomic equilibrium where Real GDP was Y* and the price-level was (Pb, Ph, Pk). The increase in exports shifts the AE function (upwards, downwards) from its original position all the way to the position labeled (AE(P), which means the AD function shifts (left, right) from its original position all the way to (ADg, ADw).
b) After the shifts in AE and AD, in the short-run the price-level (increases, decreases) to Ph due to the excess (demand, supply). This shifts the AE function (upwards, downwards) to AEw(Ph) because of the effect price-level changes are assumed to have on (consumption, investment) and on (net exports, government purchases). The economy reaches the short-run equilibrium with Real GDP equal to Yt.
c) Because Yt > Y*, the economy is producing beyond its potential level, so there is a (recession gap, inflationary gap). The rate of unemployment is (low, high) compared to the natural rate of unemployment, and there is (low, high) demand of all other productive inputs. This puts (downward, upward) pressure on the prices of factors of production, like wages. As the costs of production per unit (rise, fall) the AS curve shifts (left, right) until it reaches the position labeled (ASm, ASf).
d) With the shift of the AS curve, the price-level will (increase, decrease), which has the effect of shifting the AE curve (up, down) back to its original position and the Real GDP back to its potential level Y*.
