In the Keynesian model, what are the effects (on output, the real interest rate, and the price level) of an adverse productivity (i.e., aggregate supply) shock?

Question

What will be an ideal response?

Answer 1

When there's an adverse productivity shock, the long-run aggregate supply curve shifts to the left, while the aggregate demand curve doesn't shift, and the short-run aggregate supply curve shifts up as well. As a result, output decreases and the price level rises (assuming the short-run aggregate supply curve shifts sufficiently far up). The productivity shock shifts the FE line to the left, while the rise in the price level shifts the LM curve up and to the left. At the new intersection of the IS and LM curves, the real interest rate is higher. Assuming the LM curve shifts sufficiently far, in the long run, the price level must fall to restore general equilibrium. This reduces the real interest rate somewhat, but it remains higher than it was initially. The fall in the price level shifts the short-run aggregate supply curve down, so output rises somewhat, but remains less than it was initially. The price level also remains higher than it was initially.