Question

suppose the economy is initially in long-run equilibrium. then suppose there is a reduction in investment spending. according to the model of aggregate demand and aggregate supply, what happens to prices and output in the long run? a. prices rise and output is unchanged from its initial value. b. prices fall and output is unchanged from its initial value. c. output rises and prices are unchanged from the initial value. d. output falls and prices are unchanged from the initial value. e. output and the price level are unchanged from their initial values.

Answer 1

In the neoclassical perspective, a reduction in investment spending will initially reduce prices, but in the long run, output returns to its original level due to flexible wages and prices while the price level decreases.

Step-by-step explanation:

When there is a reduction in investment spending, according to the model of aggregate demand and aggregate supply, in the neoclassical perspective, the short-run effect might be a decrease in real GDP and a decrease in the price level due to lower demand. However, in the long run, as wages and prices adjust downwards, the short-run Keynesian aggregate supply curve shifts to the right, leading the economy back to its potential GDP. The adjustment in wages and prices offsets the initial decrease in aggregate demand, so the output returns to its initial level, and there is downward pressure on the price level.

Thus, the correct answer is: b. prices fall and output is unchanged from its initial value.