Based on the given figure, the economy is initially in long-run equilibrium at point A. If there is a favorable supply shock that increases 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

Based on the given figure, the economy is initially in long-run equilibrium at point A. If there is a favorable supply shock that increases 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 increase in potential output creates a recessionary gap in the short run as the economy is still at point A. As inflation falls, the short-run aggregate supply line shifts downward and a new long-run equilibrium is reached at point E. The long run result of an increase in potential output is a permanent increase in output and a lower inflation rate.

Based on the Given Figure, the Economy Is Initially in Long-Run