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Consider an economy that begins with real GDP equal to potential GDP. There is then a sudden increase in the prices of raw materials, which shifts the aggregate supply (AS) curve upward.
a. Draw the initial long-run equilibrium in an AD/AS diagram.
b. Now show the immediate effect of the supply shock in your diagram.
c. Suppose wages and prices in this economy adjust instantly to shocks. Explain what happens to unemployment in this economy.
d. If wages and prices adjust only slowly to shocks what happens to unemployment? Explain.
e. Based on the evidence in the Canadian economy, which is the more realistic adjustment to the AS shock?
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