Suppose the economy is initially in long-run equilibrium. Then suppose there is a drought that destroys much of the wheat crop. If policymakers allow the economy to adjust to long-run equilibrium on its own, according to the model of aggregate demand and aggregate supply, what happens to prices and output in the long run?

Question

a. Output rises; prices are unchanged from the initial value.
b. Output and the price level are unchanged from their initial values.
c. Output falls; prices are unchanged from the initial value.
d. Prices fall; output is unchanged from its initial value.
e. Prices rise; output is unchanged from its initial value.

Answer 1

In the scenario described, a drought that destroys much of the wheat crop reduces the supply of a key agricultural input, leading to a leftward shift in the short-run aggregate supply (SRAS) curve. This would cause prices to rise and output to fall in the short run due to reduced production capacity.

However, in the long run, the economy will adjust. The initial increase in prices due to decreased supply will result in higher overall price levels, but output will eventually return to its long-run potential level determined by factors such as technology, labor, and capital—assuming no permanent changes to these factors as a result of the drought.

In the long run, prices will be higher, but output will return to its long-run equilibrium level, which means that:

e. Prices rise; output is unchanged from its initial value.