Draw (in the AD/AS model) and explain what happens to the Lonely Mountain economy on its own in the long run as a result of a) if no policy response occurs. What happens to the price level, unemployment and real GDP in the long run? Include all the dynamics. Is this inflation?Explain why or why not. If so, what is it called?
The correct answer and explanation is:
In the AD/AS model, the economy starts at an equilibrium where the aggregate demand (AD) curve intersects with the long-run aggregate supply (LRAS) curve. The AD curve represents total demand in the economy, while the LRAS curve represents potential output or the full-employment level of real GDP.
When there is no policy response, and assuming some form of shock occurs (such as increased demand or decreased supply), the economy may experience inflationary or deflationary pressures. Let’s focus on what happens when there is an increase in aggregate demand, such as increased government spending or consumer confidence.
In the short run, the aggregate demand curve shifts to the right. This leads to an increase in the price level and real GDP, as firms increase production to meet the higher demand. Unemployment typically falls because more workers are needed to increase output. However, this situation is temporary, as the economy is operating beyond its long-run potential.
Over time, the short-run aggregate supply (SRAS) curve adjusts. As wages and input prices rise due to increased demand for labor and resources, the SRAS curve shifts to the left. This process leads to a higher price level and potentially a return to higher unemployment as the economy moves back toward long-run equilibrium.
In the long run, the economy returns to its potential output level (LRAS). The price level is higher than before the shock, but real GDP returns to its full-employment level. Unemployment, although initially reduced, returns to its natural rate. This is called demand-pull inflation, where inflation occurs because of an increase in aggregate demand, pushing the price level upward without a corresponding increase in real GDP in the long run.
Thus, inflation is present in this scenario, and it is specifically demand-pull inflation since it originates from an increase in aggregate demand.