Question

Use the following information to work Problems 17 and 18 In Japan, potential GDP is 600 trillion yen and the table shows the aggregate demand and short-run aggregate supply schedules. $$\begin{array}{ccc} \begin{array}{c} \text { Real GDP } \\ \text { Price } \end{array} & \begin{array}{c} \text { Real GDP supplied } \\ \text { demanded } \end{array} & \begin{array}{c} \text { in the short run } \\ \text { (trillions of 2009 yen) } \end{array} \\ \text { level } & 600 & 400 \\ \hline 75 & 550 & 450 \\ 85 & 500 & 500 \\ 95 & 450 & 550 \\ 105 & 400 & 600 \\ 115 & 350 & 650 \\ 125 & 300 & 700 \end{array}$$ a. Draw a graph of the aggregate demand curve and the short-run aggregate supply curve. b. What is the short-run equilibrium real GDP and price level?

Short answer

The short-run equilibrium occurs at a price level of 85 and a real GDP of 500 trillion yen.

Step-by-step solution

Understand the Problem

Given the information on real GDP, price levels, and both short-run aggregate supply and demand, the task is to graph these curves and find the short-run equilibrium point.

Create the Graph

Plot the real GDP demanded and real GDP supplied as a function of the price level. Use the provided data to plot the points for both curves.

Plot Aggregate Demand Curve

For each given price level, plot the corresponding real GDP demanded. Connect these points to form the aggregate demand (AD) curve.

Plot Short-Run Aggregate Supply Curve

Similarly, for each price level, plot the corresponding real GDP supplied in the short run. Connect these points to form the short-run aggregate supply (SRAS) curve.

Identify Equilibrium

The equilibrium occurs where the AD curve intersects the SRAS curve. Find this intersection point to determine the short-run equilibrium price level and real GDP.

Key concepts

Aggregate Demand Curve

Aggregate demand represents the total quantity of goods and services demanded across all levels of an economy at a particular price level. This curve typically slopes downward, showing the inverse relationship between the price level and the quantity demanded.

To understand why the curve slopes downwards, consider this:

• **Wealth Effect:** When prices fall, people feel wealthier and spend more, increasing the quantity demanded.
• **Interest Rate Effect:** Lower prices mean lower demand for money, leading to lower interest rates, which stimulate investment and consumption.
• **Foreign Exchange Effect:** As domestic prices drop, exports become cheaper and imports more expensive, again boosting aggregate demand.

Graphically, you can plot the price levels on the vertical axis and the real GDP demanded on the horizontal axis. Points given (like in the original table) help you connect the demand quantities.

This connection forms the aggregate demand curve, visualizing how demand would react to different price levels. The plotted curve helps analyze the economy's reactions to various fiscal policies or external economic changes.

Short-Run Aggregate Supply

Short-run aggregate supply (SRAS) represents the total production of goods and services that firms in an economy are willing and able to sell at a given overall price level. Unlike aggregate demand, the SRAS curve typically slopes upward.

This relationship reflects that higher prices incentivize firms to increase production due to higher profitability.

Here are a few key factors affecting SRAS:

• **Input Prices:** Lower costs (like wages) allow more production at the same price.
• **Productivity:** Higher productivity means firms can produce more, shifting SRAS right.
• **Temporary Supply Shocks:** Events like natural disasters can disrupt production, shifting SRAS left.

On a graph, you plot the price levels on the vertical axis and the real GDP supplied on the horizontal axis.

With points from the original table, connect the quantities supplied at each price level to form the SRAS curve. The curve shows how short-term changes in the economy - like an increase in demand for goods - can drive changes in production without immediately affecting the labor market or other factors.

Economic Equilibrium

Economic equilibrium occurs where the aggregate demand curve intersects the short-run aggregate supply curve. This intersection point determines the equilibrium real GDP and price level in the short run.

At this point, the quantity of goods and services that firms are willing to supply equals the quantity consumers and businesses are willing to purchase.

For instance, in the original problem:

• **Identify Equilibrium Price Level:** Locate the price at which both real GDP demanded and supplied are equal.
• **Identify Equilibrium GDP:** The corresponding GDP at this price level is the equilibrium real GDP.

In the provided data, when the price level is 85, both the real GDP demanded and supplied are 500 trillion yen.

It indicates that the economy is in equilibrium at this price level and output. This equilibrium helps policymakers understand if the economy is operating at its potential capacity or if there might be an inflationary or recessionary gap, guiding necessary fiscal or monetary interventions.