Assume that Macroland starts in a long-run equilibrium and then faces a reduction in government spending. What chain of events will lead to a new long-run equilibrium?
A) SRAS falls; then AD falls leading to a new long-run equilibrium with lower prices and lower output.
B) AD falls causing unemployment. Unemployed workers eventually accept lower wages, increasing SRAS and leading to a new long-run equilibrium with lower prices and the original output.
C) AD falls causing prices to fall. At lower prices, AD then rises back to the original level, leading to a return to the original price and output levels.
D) SRAS falls causing unemployment. With less output, investments fall leading to a reduction in LRAS and a new long-run equilibrium with lower output and higher prices.

Question

Quizplus · Accepted Answer

A reduction in government spending decreases aggregate demand (AD), causing unemployment. Over time, unemployed workers accept lower wages, which reduces production costs and increases short-run aggregate supply (SRAS). This adjustment leads to a new long-run equilibrium with lower prices and the original level of output.

Assume That Macroland Starts in a Long-Run Equilibrium and Then