Short-Run Equilibrium After Supply Shock and Fiscal Expansion

Steps:

• Initial equilibrium occurs at intersection of AD and AS at point X, determining price level and output.
• Forecasted rise in raw material costs shifts short-run AS leftward, increasing production costs and reducing output at each price level.
• Government's increased health spending shifts AD rightward, boosting total spending and increasing output demanded at each price level.
• New short-run equilibrium forms at intersection of new AD (right) and new AS (left), resulting in higher price level with output depending on shift magnitudes.

Why C is correct:

• Option C shows higher prices and lower output, matching cost-push inflation from AS shift dominating, per the aggregate supply model where input cost rises reduce potential output.

Why the others are wrong:

• A: Ignores AS contraction, overstating AD expansion's output boost.
• B: Contradicts both shocks raising prices, violating basic AD-AS shift directions.
• D: Fails to account for AS left shift's price increase, misapplying demand-side effects alone.

Final answer: C