Assume that Macroland starts in long-run equilibrium and then faces a reduction in government spending. What chain of events will lead to a new long-run equilibrium?
A) Short-run aggregate supply falls; then aggregate demand falls, leading to a new long-run equilibrium with lower prices and lower output.
B) Aggregate demand falls causing unemployment; unemployed workers eventually accept lower wages, increasing short-run aggregate supply and leading to a new long-run equilibrium with lower prices and the original output.
C) Aggregate demand falls causing prices to fall; at lower prices, aggregate demand then rises back to its original level, leading to a return to the original price and output levels.
D) Short-run aggregate supply falls causing unemployment; with less output, investment falls, leading to a reduction in long-run aggregate supply and a new long-run equilibrium with lower output and higher prices.

Question

Quizplus · Accepted Answer

A reduction in government spending would reduce aggregate demand and cause unemployment in the short-run. This would lead to a decrease in wages, increasing short-run aggregate supply. Eventually, this increase in short-run aggregate supply will bring the economy to a new long-run equilibrium with lower prices and the original output level, as the economy adjusts to the reduction in government spending. Hence, option B is the most suitable choice.

Assume That Macroland Starts in Long-Run Equilibrium and Then Faces