IAI Actuarial Core Principles · Business Economics · Supply-side policies and their impact on businesses
An economy is operating with real output at its full-employment level and the aggregate supply curve is vertical in the long run. A package of supply-side reforms succeeds in raising potential output by 4%. Aggregate demand is unchanged. Which outcome is most likely, other things equal?
The price level falls and equilibrium real output increases. With aggregate demand unchanged, a rightward shift in long-run aggregate supply moves equilibrium along the downward-sloping demand curve, giving lower prices and higher output. Output rises by less than the full 4% shift in potential, so the 4% option is wrong.
- AThe price level rises and real output is unchanged
- BThe price level falls and equilibrium real output increasesCorrect
- CBoth the price level and real output remain unchanged
- DReal output falls because of lower demand for labour
- The price level rises and real output increases by exactly 4%
Explanation
A rightward shift of long-run aggregate supply with fixed aggregate demand moves equilibrium to a lower price level and higher output, along the downward-sloping demand curve. Output rises by less than 4% unless demand is perfectly elastic in price terms. The price level therefore falls, and the final option, which has prices rising, is wrong.
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