Question

Suppose that AD and AS intersect at an output level that is higher than the full-employment output level. After the economy adjusts back to equilibrium in the long run, the price level will be _______.

a. higher than it is now

b. lower than it is now

c. the same as it is now

Short answer

The correct option is (a): In the long run, the price level after adjustment will be higher than the initial price level.

Step-by-step solution

The explanation for correct option (a)

If the equilibrium output is higher than the potential output, it implies a positive output gap or inflationary gap in the economy.So, in the long run, the workers can correctly anticipate the rise in price level and demand higher wages. It would cause the nominal wages or input prices to rise.As a result, the producers would cut short their output level due to a rise in production costs, leading to a leftward shift in the short-run aggregate supply curve.

Thus, the output would revert to the full employment level, and the price level or inflation rate would rise further. Hence, after adjustment price level would be higher than the initial price.

So, the correct option is (a).

The explanation for incorrect options (b) and (c) 

There is a positive output gap or inflationary gap in the economy, so the economy's price level rises in the short run. During long-run adjustment, the nominal wages and input prices would rise, leading to a leftward shift in the short-run aggregate supply curve; so, there will be a further rise in the price level.

However, if the long-run price level is lower than the initial price level, the real output level would rise further in the long run, and full employment conditions cannot be restored. So, option (b) is incorrect.

However, if the long-run price level is the same as the initial price level, the real output level would not change, and full employment conditions cannot be restored. So, option (c) is incorrect.