Suppose that aggregate demand were suddenly to shrink by 5 percent because of a crisis affecting exports. You would expect, in the absence of any policy adjustment,
A) that employment would climb above full employment briefly but fall back in the long run as prices rose.
B) a period of increased unemployment in the short run that would be reversed in the long run by a reduction in inflation and prices, for which aggregate demand could again equal potential GDP.
C) no change in employment or prices, because the aggregate demand curve would still intersect aggregate supply above potential GDP.
D) some type of price adjustment in the export market that would cancel the export contraction.
E) none of the above.

Question

Quizplus · Accepted Answer

A sudden shrinkage in aggregate demand, such as a crisis affecting exports, would initially lead to increased unemployment due to reduced economic activity. Over time, however, the decrease in demand would likely lead to lower inflation and prices. This adjustment would make goods and services cheaper, eventually stimulating demand again and moving the economy back towards its potential GDP, where unemployment rates are normalized. This process describes a self-correcting mechanism in the economy, assuming no policy interventions are made to counteract the initial shock.

Suppose That Aggregate Demand Were Suddenly to Shrink by 5