Use Exhibit 4 to answer question

Question

Suppose the economy is operating in a recession such as point B in Exhibit 4. If policymakers allow the economy to adjust to the long-run natural level on its own,
a. people will raise their price expectations and aggregate demand will shift left.
b. people will reduce their price expectations and aggregate demand will shift right.
c. people will raise their price expectations and the short-run aggregate supply will shift left.
d. people will reduce their price expectations and the short-run aggregate supply will shift right.

Answer 1

In a recession, such as point B in Exhibit 4, when the economy is allowed to adjust to the long-run natural level on its own, the typical response involves changes in expectations and adjustments in aggregate supply rather than aggregate demand.

People’s price expectations will generally decline in response to lower economic activity, labor slack, and reduced demand for goods and services. This change in expectations usually leads firms to lower prices and costs, prompting the short-run aggregate supply (SRAS) to shift to the right as firms adjust their output to match the new equilibrium.

Therefore, the correct answer to your question is:

d. people will reduce their price expectations and the short-run aggregate supply will shift right.