Question

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

Short answer

Answer: When aggregate demand increases, the aggregate demand curve shifts to the right. If the aggregate supply curve is vertical (indicating a classical long-run aggregate supply curve), the new equilibrium point will be vertically aligned with the initial point, meaning that real GDP remains unchanged. Instead, the price level increases as the new equilibrium forms. One possible reason for this situation is that the economy is at full employment in the long run, with a fixed potential GDP. In this case, any change in aggregate demand will only have an impact on the price level but not on the real GDP itself.

Step-by-step solution

Understand aggregate demand and aggregate supply

First, we need to understand aggregate demand (AD) and aggregate supply (AS). Aggregate demand is the total demand for all goods and services in an economy, while aggregate supply is the total supply of all goods and services produced in an economy. The aggregate demand and aggregate supply curves show the relationship between the price level and output (real GDP) in an economy.

Draw the initial aggregate demand and aggregate supply diagram

Draw the initial aggregate demand (AD) curve downward sloping and the aggregate supply (AS) curve upward sloping. Label the intersection of the AD and AS curves as point A, which represents the initial equilibrium level of real GDP and price level (P).

Identify the initial equilibrium

At point A, the aggregate demand and aggregate supply are in equilibrium, meaning that the quantity of goods and services demanded by households and businesses equals the quantity of goods and services supplied by producers. This results in a stable price level and level of real GDP.

Illustrate the shift in aggregate demand

Now, we need to show the increase in aggregate demand. To do this, shift the AD curve to the right, which represents an increase in the demand for goods and services. Label the new aggregate demand curve as AD1.

Analyze the effect of the aggregate demand shift

As aggregate demand increases (shifts to the right), the equilibrium point moves along the aggregate supply (AS) curve. However, since we know that there is no change in real GDP, the new equilibrium point must be vertically aligned with point A. This means that the new equilibrium output level is the same as the initial level, but the price level has increased. Label this new intersection point as B.

Explain the possible reason for the observed phenomenon

One possible reason for this scenario is that the aggregate supply curve is vertical, which is an indication of a vertical (or classical) long-run aggregate supply curve. In the long run, it is assumed that the economy is at full employment, meaning that the potential GDP is fixed, and any change in aggregate demand will only have an impact on the price level but not on the real GDP itself. In conclusion, the exercise demonstrates a situation where an increase in aggregate demand causes an increase in the price level but no change in real GDP. This occurs when the AD curve shifts to the right, but the equilibrium output level remains the same due to a vertical long-run aggregate supply curve.