Indifference curve, graph, income effect and substitution effect, a level economics

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Question 15: US the AD-AS model to show and explain how a decrease in productivity.

We can explain the process in 3 steps.

I- the short-run aggregate supply curve will shift leftwards as the Economy’s production capacity will be decreased and consequently, the price Levels in the economy will rise along with a decrease in real output (also Increasing the unemployment rate).

II- simultaneously, given that price levels have increased during This SR interval, we can expect AD to decrease with a leftward movement along Its curve, given that the wealth effect decreases consumption and the opportunity Cost of holding money rises (assuming that rising price levels are accompanied With increases in the interest rate and inflation). Additionally, investment Decreases as profit margins decrease (higher input costs) and the cost of Borrowing increases, ultimately leading to an international substitution effect In which imports increase relative to exports. This new point is the SR Equilibrium- characterized by a higher price level and lower output.

III- In the LR, the Potential output of the economy will have a leftwards shift. The vertical LRAS Curve will meet the ‘new’ short run equilibrium that was previously Established. The reason for this is that developmental economics has proven the LR output potentials are determined by the productive capabilities of an Economy. A simplified production function (Y= y(K,L) tells us that capital and Labor are the keys to LR potential, and a decrease in productivity will Consequently have a negative effect. We now have a new LR equilibrium, with Lower output, higher unemployment, higher price level and a LRAS curve below What it used to be.

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