Question

Suppose aggregate demand increases, causing an increase in real GDP but no change in the price level. Using an aggregate demand and aggregate supply diagram, illustrate and explain how this could occur.

Short answer

Question: Explain a situation in which an increase in aggregate demand leads to an increase in real GDP but does not affect the price level. Answer: This situation can occur if the economy is operating below its full capacity, with idle resources such as unemployed workers and underutilized factories. When aggregate demand increases in such a scenario, firms can increase production without raising prices by utilizing the existing idle resources to meet the higher demand. As a result, real GDP increases, but the price level remains constant. This situation is consistent with the Keynesian view of macroeconomics and is more likely to occur during economic downturns or recessions when there are unused resources in the economy.

Step-by-step solution

Understand Aggregate Demand and Aggregate Supply

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 produced by firms. When people spend, the aggregate demand curve shifts to the right, leading to an increase in the price level and real GDP. Aggregate supply, on the other hand, shows the total output produced by the economy, taking into account available resources and production technology.

Draw the initial Aggregate Demand and Aggregate Supply diagram

Start by drawing a coordinate plane, with the price level (P) on the vertical axis and real GDP (Y) on the horizontal axis. Draw an upward-sloping aggregate supply curve (AS) and a downward-sloping aggregate demand curve (AD). The point where these two curves intersect represents the initial equilibrium, with equilibrium price level (P1) and equilibrium real GDP (Y1).

Illustrate an increase in Aggregate Demand

Now, show an increase in aggregate demand by shifting the aggregate demand curve to the right, from AD to AD'. This increase could be due to various factors such as an increase in consumer spending, government spending, investment, or net exports. The new point where the AD' and AS curves intersect represents the new equilibrium, with the new equilibrium price level (P2) and new equilibrium real GDP (Y2).

Analyze the new equilibrium

According to the problem, the increase in aggregate demand should lead to an increase in real GDP but no change in the price level. This means that the new equilibrium point must lie on the same horizontal line as the initial equilibrium (i.e., P2 = P1). In other words, the price level remains unchanged despite an increase in aggregate demand.

Explain how this could occur

This scenario can occur if the economy is operating below its full capacity, and there are idle resources (e.g., unemployed workers, underutilized factories). In such a situation, an increase in aggregate demand can encourage firms to increase production without raising prices, as they can utilize the existing idle resources to meet the increased demand. Therefore, real GDP increases, but the price level remains constant. This situation is known as the Keynesian (or demand-side) view of macroeconomics and is more applicable during economic downturns or recessions when there are unused resources in the economy. By following these steps, we illustrated and explained a situation where an increase in aggregate demand causes an increase in real GDP but no change in the price level, using an aggregate demand and aggregate supply diagram.

Key concepts

Aggregate Demand

Understanding the concept of aggregate demand (AD) is crucial for deciphering economic performance in macroeconomics. It defines the total amount of goods and services that households, businesses, government, and foreign buyers collectively wish to purchase at a given price level over a particular period.

Think of it as an economy's collective 'shopping list' which can expand or shrink based on various factors like consumer confidence, fiscal policies, and changes in income levels. An easy way to visualize it is by imagining people in a marketplace—more people willing to spend equates to higher aggregate demand.

A significant feature of AD is that it tends to increase as the price level falls, due to the wealth effect, interest rate effect, and exchange rate effect, which boosts consumers' purchasing power. Understanding how AD shifts is a foundational skill for economists as it helps predict inflationary or recessionary trends.

Real GDP

Real Gross Domestic Product (real GDP) is a metric that encapsulates the economic output of a country, adjusted for inflation, over a specific period. This adjustment is vital because it allows for comparisons of economic performance over time without the skewing effects of changing price levels.

It's like scoring points in a game; the total score (or GDP) tells you how the economy performed, and by adjusting for inflation (making it 'real'), we ensure the score is not inflated and therefore comparable to previous periods. Real GDP is key to assessing an economy's health and to confirm whether it's growing or contracting, and by how much. An increase in real GDP typically signifies an expansion in economic activity and can be tied to improvements in productivity, technological advances, and increases in the labor force.

Price Level

Price level in macroeconomics is like a snapshot of the average of current prices across the entire spectrum of goods and services produced in the economy. It is a measure of inflation and is crucial when evaluating the purchasing power of money.

Imagine going to a supermarket with a bag full of money. The price level will determine how much you can fill your cart. If the price level rises, each dollar buys you less, just like if the bag of money suddenly had fewer bills—it's the same amount of money, but its value has dropped. In economic diagrams, the price level is often represented on the vertical axis of the aggregate demand and supply graph. It's essential to understand that the price level is not the same as the prices of individual goods and services; rather, it reflects the general pricing trend in the economy.

Macroeconomics

Macroeconomics is the branch of economics that examines the behavior and performance of an entire economy rather than individual markets. This includes looking at variables like unemployment rates, national income, rate of growth, gross domestic product, inflation, and price levels.

It's akin to an aerial view of a vast landscape, which in this case is the economy, observing broad patterns and how different systems interact with each other. Macroeconomics helps government and policy makers decide on interest rates, tax policies, and government spending to regulate economic growth, control inflation, and reduce unemployment. The macroeconomic perspective is essential for understanding the big picture of economic policy and its impact on businesses and individuals.

Economic Equilibrium

Economic equilibrium is like a seesaw perfectly balanced, with supply on one side and demand on the other. It's achieved when the quantity of goods and services sought by buyers is equal to the quantity supplied by sellers. This balance point determines the market price and volume of goods sold.

In the context of AD and AS, economic equilibrium occurs where the aggregate demand curve intersects with the aggregate supply curve. This intersection point represents the equilibrium price level and output. If any changes occur, such as an increase in aggregate demand, it causes a temporary imbalance—equilibrium shifts until it finds a new point of balance. Policymakers strive to maintain this equilibrium for economic stability, as imbalances can lead to inflation or unemployment.