Use the following to answer questions . Exhibit: Using the Aggregate Demand/Aggregate Supply Model 1 -(Exhibit: Using the Aggregate Demand/Aggregate Supply Model 1) Suppose the economy is initially at point A. Now suppose an increase in government purchases shifts the aggregate demand curve to AD₂. Which of the following statements best explains how the economy responds to restore long-run macroeconomic equilibrium? A) The increase in the price level to P_b reduces real GDP demanded, shifting the aggregate demand curve back to AD₁, returning the economy to its potential output at A. B) Firms produce more in anticipation of future higher prices, thus shifting the SRAS curve upward until the gap is eliminated at D. C) Firms and workers will negotiate higher nominal wages to restore lost purchasing power. This shifts the SRAS curve to the left until the gap is eliminated at D. D) The increase in the price level to P_b decreases consumption which in turn leads firms to cut production shifting the SRAS curve to the left until the gap is eliminated at D.

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In response to higher demand and prices, firms and workers negotiate higher wages, increasing production costs and shifting the SRAS curve left, restoring equilibrium at a higher price level.

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