In the given figure, the economy is initially in long-run equilibrium at point A. If there is an adverse supply shock that reduces potential output and shifts the long-run aggregate supply curve from LRAS to LRAS', then the new long-run equilibrium is reached at point:
A)E.
B)B.
C)C.
D)D.

Question

In the given figure, the economy is initially in long-run equilibrium at point A. If there is an adverse supply shock that reduces potential output and shifts the long-run aggregate supply curve from LRAS to LRAS', then the new long-run equilibrium is reached at point: 
A)E. 
B)B. 
C)C. 
D)D.

Quizplus · Accepted Answer

The decline in potential output creates an expansionary gap in the short run as the economy is still at point A. As inflation rises, the short-run aggregate supply line shifts upward and a new long-run equilibrium is reached at point C. The long run result of a fall in potential output is a permanent decline in output and a higher inflation rate.

In the Given Figure, the Economy Is Initially in Long-Run