Assuming the economy is in short-run equilibrium with output y1 and price level p2, the economy is now in a recession gap. Increase government spending.
In the short term, the economy will move from point A to point B, producing less output and lowering the price level. In the long run, the short-run aggregate supply curve shifts to the right and returns to equilibrium at point C, output remains unchanged, and price levels fall relative to point A.
In the long run, firms face both variable and fixed costs, meaning that production, wages, and prices do not have complete freedom to reach a new equilibrium. Equilibrium refers to the point at which opposing forces are balanced.
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