1. Consider an economy that is initially in long run equilibrium in the Aggregate Demand and Aggregate Supply (AD-AS) diagram that we covered in lectures. Suppose many Australian firms mistakenly expect that there will be an increase in the relative price of their own products as compared to others (including relative to the input costs and wages they pay). Start with the equilibrium point shown in the Figure below and use it to demonstrate the following changes.
a) How does this change the aggregate price level, real income and unemployment in the short run? Explain and illustrate in the AD-AS diagram.
Answer here (Tips: to create new lines, simply copy the existing curves and move to the new location)
SRAS0
P
Y
YLR
P0
LRAS0
b) Explain the adjustment process to long run equilibrium (assuming that real potential output remains unchanged, so no change in LRAS), and what happens to the price level. No need to demonstrate it in Figure but it may be helpful.