2. A rise in productivity increases potential output, but some worry that demand for the additional output will be insufficient even in the long run. How would you respond?
As the rise in productivity increases potential output, the long-run aggregate supply curve shifts to the right. If, in the short run, there is now a recessionary gap (aggregate output is less than potential output), 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 be equal to potential output.
Solutions appear at back of book.