Describe the short-run effects of each of the following shocks on the aggregate price level and on aggregate output:
The government sharply increases the minimum wage, raising the wages of many workers.
An increase in the minimum wage raises the nominal wage and, as a result, shifts the shortrun aggregate supply curve to the left. As a result of this negative supply shock, the aggregate price level rises and aggregate output falls.
Solar energy firms launch a major program of investment spending.
Increased investment spending shifts the aggregate demand curve to the right. As a result of this positive demand shock, both the aggregate price level and aggregate output rise.
Congress raises taxes and cuts spending.
An increase in taxes and a reduction in government spending both result in negative demand shocks, shifting the aggregate demand curve to the left. As a result, both the aggregate price level and aggregate output fall.
Severe weather destroys crops around the world.
This is a negative supply shock, shifting the short-run aggregate supply curve to the left. As a result, the aggregate price level rises and aggregate output falls.
Question
Suppose a rise in productivity increases potential output and creates a recessionary gap. Explain how the economy can self-correct in the long run.
As economic growth increases potential output, the long-run aggregate supply curve shifts to the right. If, in the short run, a recessionary gap (aggregate output is less than potential output) now exists, nominal wages will fall, shifting the short-run aggregate supply curve to the right. This results in a fall in the aggregate price level and a rise in aggregate output. As prices fall, we move along the aggregate demand curve due to the wealth and interest rate effects of a change in the aggregate price level. Eventually, as long-run macroeconomic equilibrium is reestablished, aggregate output will rise to become equal to potential output, and the aggregate price level will fall to the level that equates the quantity of aggregate output demanded with potential output.