Question

In the chapter titled ‘‘Macroeconomic Equilibrium: Aggregate Demand and Supply,’’ the aggregate supply (AS) curve was upward sloping. Now, in this chapter, we have a flat AS curve. What are the implications for equilibrium real GDP if AD shifts by some amount and the AS curve is perfectly flat in one economy and upward sloping in another?

Short answer

Answer: In an economy with a flat Aggregate Supply curve, a shift in Aggregate Demand will result in a change in equilibrium real GDP without any impact on the price level. However, in an economy with an upward sloping Aggregate Supply curve, a shift in Aggregate Demand will affect both the price level and real GDP, with changes in real GDP being less pronounced than changes in nominal GDP due to the influence of price level changes.

Step-by-step solution

Understanding Aggregate Demand and Aggregate Supply curves

Aggregate Demand (AD) represents the total demand for goods and services in an economy, while Aggregate Supply (AS) represents the total supply of goods and services. In the context of this exercise, we have two types of AS curves - a flat (horizontal) AS curve and an upward sloping AS curve. The flat AS curve suggests that the supply of goods and services remains constant at all price levels, meaning that the economy can produce any level of output without any change in the price level (no inflationary pressure). The upward sloping AS curve indicates that as the level of demand increases, so does the supply for goods and services, leading to an increase in the overall price level (inflationary pressure).

Analyzing the effect of a shift in AD on the equilibrium real GDP for an economy with a flat AS curve

When AD shifts and the AS curve is perfectly flat, it means that regardless of the shift in AD, the price level remains constant. Therefore, in this scenario, the entire change in AD would translate into a change in real GDP. For example, if AD increases (shifts right), the equilibrium real GDP will also increase, potentially indicating an improvement in the economy's overall performance. Conversely, if AD decreases (shifts left), the equilibrium real GDP would decrease, which might signal a slowdown in the economy.

Analyzing the effect of a shift in AD on the equilibrium real GDP for an economy with an upward sloping AS curve

In the case of an upward sloping AS curve, the economy is subject to inflationary pressure as the demand for goods and services increases. When AD shifts right (increase in demand), the price level will increase due to the higher demand, and so will the real GDP. However, the increase in real GDP will be less than the increase in nominal GDP because of the increase in the price level. Likewise, when AD shifts left (decrease in demand), the price level will decrease due to the lower demand, and the real GDP will decrease as well. However, the decrease in real GDP will be less than the decrease in nominal GDP because of the decrease in the price level.

Comparing the implications for the equilibrium real GDP in both economies

The key difference between the two economies lies in the effect that shifts in AD have on the price level and real GDP: - In the economy with a flat AS curve, the entire change in AD translates into a change in real GDP, with no impact on the price level. - In the economy with an upward sloping AS curve, a shift in AD affects both the price level and real GDP. Changes in real GDP are less pronounced than changes in nominal GDP due to the influence of price level changes. In conclusion, the implications for equilibrium real GDP in response to a shift in AD depend on the type of AS curve present in an economy. An economy with a flat AS curve will experience more significant changes in real GDP without affecting the price level, whereas an economy with an upward sloping AS curve will experience changes in both real GDP and the price level.

Key concepts

Aggregate Demand and Supply

Understanding the interplay between Aggregate Demand (AD) and Aggregate Supply (AS) is critical for grasping macroeconomic equilibrium.

AD embodies the total demand for goods and services within an economy, indicating what consumers, businesses, and governments are willing to purchase at various price levels. Changes in AD can be influenced by several factors, such as fiscal policy, monetary policy, and changes in the expectations of consumers and firms.

On the other hand, AS represents the total output of goods and services that businesses are prepared to supply at different price levels. A flat AS curve implies producers can increase their output without raising prices, often due to excess capacity or resource availability. Conversely, an upward sloping AS curve suggests limited capacity, where an increase in production leads to higher prices due to costs like labor becoming more expensive.

The point where the AD curve intersects with the AS curve signifies the equilibrium level of output (Equilibrium Real GDP), which is where the economy tends to gravitate toward in the long run.

Equilibrium Real GDP

Equilibrium Real GDP occurs at the point where the total output (AS) perfectly matches the total economy-wide demand (AD). When the AS curve is flat, if AD increases or decreases, the entire change is absorbed by a corresponding rise or fall in real GDP.

This means that producers can satisfy higher demand without raising prices, thus the quantity of goods and services produced increases, which directly enlarges the real GDP. This situation typically occurs when an economy is not operating at full capacity. For example, during an economic recession, an increase in AD can lead to a rise in production and employment without inflation.

However, when the AS curve is upward sloping, an increase in AD will not only raise the output but also the price levels (inflationary pressure). This situation indicates that the economy might be nearing full capacity. Firms cannot increase production without facing higher costs themselves, leading to inflation, which in turn moderates the increase in real GDP.

Inflationary Pressure

Inflationary pressure emerges when an increase in AD corresponds with higher prices, rather than just an increase in the volume of goods and services produced. This effect is predominantly associated with an upward sloping AS curve.

When businesses face capacity constraints or higher costs of production, they respond to increased demand by raising prices. As a result, consumers see their purchasing power erode, which can moderate their spending, thereby affecting overall economic growth.

In the context of an AD shift with a flat AS curve, there is no inflationary pressure because price levels stay constant as output changes. On the other hand, the upward sloping AS curve captures the realistic tendency for prices to increase as demand outpaces the current production capacity. Policymakers closely monitor inflationary pressure because it can signal an overheating economy and may necessitate actions such as tightening monetary policy to prevent runaway inflation.