Question

Critical analysis Q8 When actual output exceeds an economy’s full-employment output, how will the self-correcting mechanism direct the economy to long-run equilibrium? Prices will increase causing production costs, which will reduce aggregate supply. In the long run, a new equilibrium will emerge at a higher price level and an output consistent with the economy’s sustainable capacity. Weak demand will pull real wages and other costs downward, increasing profit margins and leading to an expansion of aggregate supply. In the long run, a new equilibrium will emerge at a higher price level and an output consistent with the economy’s sustainable capacity.

Answer 1

Answer: Prices will increase causing production costs, which will reduce aggregate supply. In the long run, a new equilibrium will emerge at a higher price level and an output consistent with the economy’s sustainable capacity.

Explanation:

When an Inflationary Gap ( Real GDP higher than GDP at full employment) occurs in the Economy, it signifies that there are higher funds in the economy for consumers to spend.

As consumers demand more goods, producers increase prices and make profit. This encourages their employees to seek better wages and as well for raw material costs to increase due to a rise in demand for those by the production companies.

This rise in production costs further increases the price of goods and reduces production until they arrive at an Equilibrium level in the long run that the Economy can support with the resources that it has.