If we are already in LR equilibrium, an unexpected increase in AD will cause real GDP to increase:
a.Only in the long run.
b.Only in the short run.
c. In both the short run and the long run
d.In neither the short run nor the long run.
The correct answer and explanation is:
The correct answer is b. Only in the short run.
When aggregate demand (AD) increases unexpectedly, it initially leads to higher real GDP in the short run due to an increase in output and employment. In the short run, firms can respond to the increased demand by utilizing their idle resources, such as labor and capital, to produce more goods and services. As firms increase production, real GDP rises, and unemployment tends to decrease. This is the immediate effect of an increase in AD.
However, in the long run, the economy returns to its natural level of output, known as the long-run equilibrium, as determined by the potential or full employment output. This is because, in the long run, prices and wages are flexible. When AD increases, the increased demand leads to upward pressure on prices, which causes wages to rise as well. Higher wages and costs of production reduce firms’ profitability, which leads to higher prices for goods and services (inflation). As the economy adjusts, the short-run increase in GDP is eventually neutralized as the higher price levels push the economy back to its original long-run equilibrium.
In summary, the effect of an unexpected increase in AD is temporary. It boosts real GDP and reduces unemployment in the short run. However, once prices and wages adjust, the economy returns to its potential output level in the long run, where there is no change in real GDP. The long-run adjustment restores the economy to its natural level of output, meaning that the initial increase in AD does not have a lasting effect on real GDP in the long run.