The economy in the diagram below begins in long-run equilibrium at E0.
FIGURE 30-2
-Refer to Figure 30-2.Suppose the economy is in a short-run equilibrium at E1 after a negative supply shock.How will cyclical unemployment be reduced in the absence of any government policy intervention?

Question

The economy in the diagram below begins in long-run equilibrium at E0.
  FIGURE 30-2
-Refer to Figure 30-2.Suppose the economy is in a short-run equilibrium at E1 after a negative supply shock.How will cyclical unemployment be reduced in the absence of any government policy intervention?

Quizplus · Accepted Answer

In the short-run, a negative supply shock causes a leftward shift of the AS curve, leading to a new short-run equilibrium at E1 with higher unemployment and inflation. However, over time, the excess supply of labour at E1 will put downward pressure on wages, causing firms to reduce their costs and shift the AS curve back to AS0. This will eventually bring the economy back to full employment at E0, with lower cyclical unemployment. Therefore, choice B is the best answer. Choice A is incorrect because labour market flexibility takes time to improve and may not be enough to reduce the unemployment caused by a supply shock. Choice C is incomplete because it does not explain how AD grows, and it is not necessarily the only way to reduce cyclical unemployment. Choice D is incorrect because it assumes that the natural rate of unemployment remains constant after a supply shock, which is unlikely. Choice E may not be a feasible solution because it requires an increase in government purchases, which may not be desirable or possible in all situations.

The Economy in the Diagram Below Begins in Long-Run Equilibrium