ECON 2450 Department of Economics
Intermediate Macroeconomic Theory II York University
Instructor: Sharif F. Khan Winter 2013
Suggested Solutions to Assignment 1 (OPTIONAL)
Total Marks: 35
Figure 8.6 illustrates the effects of a demand shock. The economy begins in equilibrium
at point A, where the LRAS, SRAS, and AD curves intersect. An adverse demand shock
shifts the aggregate demand curve to the left to AD'. In the short run, the equilibrium is at
point B, where AD' intersects SRAS. This is a point at which output has declined (a
recession), but the price level is unchanged. Over time, the short-run aggregate supply
curve shifts down to SRAS, restoring long-run equilibrium at point C. At this point,
output is back at its full-employment level and the price level has declined. Thus the
result of an adverse demand shock on the price level is that the price level is unchanged
in the short run and declines in the long run. Since the 1973-1975 recession was one in
which the price level rose sharply, it must not have been due to an adverse demand shock.
Instead, it is an adverse supply shock that rationalize such behavior.
Figure 8.7 illustrates how a negative supply shock creates inflation in the long-run. The
economy begins in equilibrium at point A, where the LRAS, and AD curves intersect.
The supply shock shifts the long-term aggregate supply curve to the left to LRAS'. The
new equilibrium is at point B, where AD intersects LRAS’. This is a point at which
output has declined (a recession), and the price level increased.
Growth that is "too rapid" most likely refers to a situation in which the aggregate demand
curve has shifted to the right and, in the short run, intersects the SRAS curve at a level of
output that's greater than the full-employment level of output. This situation is associated
with inflation because, in the long run, prices will rise, shifting the SRAS curve up to
intersect with the LRAS and AD curves. The shock that is implicitly assumed to be hitting
the economy is an aggregate demand shock, since that's the only shock that incre