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Suppose that firms become very optimistic about future business conditions and invest heavily in new capital equipment.a. Use an aggregate-demand/aggregate-supply diagram to show the short-run effect of this optimism on the economy. Label the new levels ofprices and real output. Explain in words why the aggregate quantity of output supplied changes.b. Now use the diagram from part (a) to show the new long-run equilibrium of the economy. (For now, assume there is no change in the long-run aggregate-supply curve.) Explain in words why the aggregate quantity of output demanded changes between the short run and the long run.c. How might the investment boom affect the long run aggregate-supply curve? Explain.
Solution:- Lets assume the economy begins in long-run equilibrium at point a, with price level P1 and output level Q1 at the intersection of AD1 and short-run AS1. If firms become optimistic about future business conditions, they will tend to invest more, so the AD curve shifts to the right to AD2. Now the economy is at point b, with price level P2 and output level Q2. The aggregate quantity of output supplied rises because the price level has risen and people have misperceptions about the price level, and/or wages are sticky, and/or prices are sticky, all of which cause output supplied to increase. b) Over time, as the misperceptions of the price level disappear, and/or wages adjust, and/or prices adjust, the short-run AS curve…

shifts up to AS2 and the economy reaches equilibrium at point c, with price level P3 and output level back at Q1. The quantity of output demanded declines as the price level rises because of the wealth effect, the interest rate effect, and the exchange rate effect, all of which lead to lower AD at higher prices. c) The investment boom might affect the long-run AS curve because higher investment today means a larger capital stock in the future, thus leading to higher productivity and higher output.



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