Austerity and Wage Hike
The question
Assume the economy of Vasquin is initially in long-run equilibrium. To close a large budget deficit, the government sharply reduces its purchases of goods and services, and in the same year a round of newly negotiated multi-year labor contracts raises the nominal wages that firms across Vasquin must pay, with worker productivity unchanged. Assume the central bank takes no action and that Vasquin's quantity of resources and level of technology are unchanged. Show the short-run effect on Vasquin's economy, holding all else constant. Show the effect on the AD-AS Model graph.
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Austerity and Wage Hike: the worked answer
On the AD-AS Model graph, AD shifts left and SRAS shifts left.
Why AD shifts left and SRAS shifts left
Government purchases are a component of aggregate demand, so cutting them lowers total spending at every price level and aggregate demand shifts to the left. Separately, higher nominal wages with no offsetting productivity gain raise firms' per-unit production costs, so firms are willing to supply less output at every price level and short-run aggregate supply shifts to the left. The economy's quantity of resources and its level of technology are unchanged, so long-run aggregate supply stays put. Both shifts reduce equilibrium output, so real GDP definitely falls. The two shifts push the price level in opposite directions, because weaker spending pushes it down while higher costs push it up, so the change in the price level is indeterminate and depends on which shift is larger.
What happens to the equilibrium
Real GDP definitely falls and a recessionary gap opens, while the price level is indeterminate and depends on whether the spending cut or the wage increase is the larger shift.
The mistake students make on this one
Most wrong answers sign both outcomes, usually as "real GDP falls and the price level falls", treating the spending cut as the whole story and forgetting that the wage shock pushes prices the other way. The mirror-image error, calling this stagflation with a definitely higher price level, is equally unsupported. Only output is pinned down here, and a student who writes a specific price-level direction has claimed to know a magnitude the stem never gave.
On exam day
When both curves shift the same way along the horizontal axis, the output answer is the safe point and the price level is the trap, so write "indeterminate" for it instead of reading a direction off whichever shift you happened to draw bigger.
How this is graded
The checker reads every curve's position before and after your answer. You are marked correct only when AD shifts left and SRAS shifts left and every other curve on the AD-AS Model graph stays where it started — the same standard an AP reader applies to a drawn graph: the right shift, and nothing extra. There is no AI involved; the rubric is the geometry.
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