Question

Draw and carefully label an aggregate demand and supply diagram with initial equilibrium at P0 and Y0. a. Using the diagram, explain what happens when aggregate demand falls. b. How is the short run different from the long run?

Short answer

Answer: In the short run, a fall in aggregate demand results in a decrease in both price level (deflation) and real GDP (recession), causing unemployment and lower incomes. However, in the long run, the economy adjusts to the new aggregate demand level, and the price level and real GDP reach a new equilibrium point. The long-run adjustment may involve structural changes in the economy, such as the reallocation of resources and labor, to reach the new potential output level.

Step-by-step solution

Draw the Aggregate Demand and Supply Diagram

First, draw a graph with the horizontal axis labeled "Real GDP (Y)" and the vertical axis labeled "Price Level (P)." Draw a downward sloping aggregate demand curve (AD) and an upward-sloping short-run aggregate supply curve (SRAS). Label the intersection point of AD and SRAS as E0, representing the initial equilibrium point where P=P0 and Y=Y0.

Illustrate the Fall in Aggregate Demand

Now, draw a new downward-sloping aggregate demand curve (AD1), representing the fall in aggregate demand. This curve should be to the left of the original AD curve. The intersection of this new curve and the original SRAS curve is the new short-run equilibrium (E1) with price level P1 and real GDP Y1.

Explain the Effects of the Fall in Aggregate Demand

When aggregate demand falls, it results in a new short-run equilibrium at a lower price level (P1) and lower real GDP (Y1) compared to the initial equilibrium (P0 and Y0). This decline in real GDP implies that there is less output being produced in the economy, and as a result, there may be unemployment and lower incomes.

Describe the Long-Run Situation

In the long run, the economy adjusts to the fall in aggregate demand. This adjustment comes through a downward-sloping long-run aggregate supply curve (LRAS) intersecting both AD and SRAS curves at the same point. In the long run, the economy experiences a decrease in potential output and a new long-run equilibrium point (E2) at a lower price level (P2) compared to the initial equilibrium.

Explain the Differences Between the Short Run and Long Run

In the short run, the fall of aggregate demand results in a decrease in both price level (deflation) and real GDP (recession), causing unemployment and lower incomes. However, in the long run, the economy adjusts to the new aggregate demand level, and the price level and real GDP reach a new equilibrium point. The long-run adjustment may involve structural changes in the economy, such as the reallocation of resources and labor, to reach the new potential output level.

Key concepts

Equilibrium

Equilibrium in the context of aggregate demand and supply refers to the point where aggregate demand (AD) and aggregate supply (AS) intersect on a graph. At this intersection, the quantity of goods and services produced in the economy (Real GDP) matches the quantity demanded at a certain price level. This forms the equilibrium price and output level.

In the initial scenario, equilibrium occurs at a point labeled as E0, with Real GDP (Y0) and price level (P0). This indicates a state where the economy is balanced and there is no tendency for either prices or output to change, assuming external factors remain constant.

When there are shifts in aggregate demand or supply, equilibrium changes. For instance, if AD decreases, a new equilibrium, like E1, is formed at a lower price level and output. Understanding equilibrium helps in analyzing how economies respond to changes.

Short-run vs Long-run

The distinction between the short run and long run in economic analysis is crucial. It helps us understand how economies react to various changes over different time horizons.

**Short-Run Adjustments**
In the short run, prices and some factors of production, such as wages, are sticky and do not adjust immediately. When aggregate demand falls, the short-run equilibrium moves to a lower output and price level, leading to economic outcomes like higher unemployment and reduced income.

**Long-Run Adjustments**
Over the long run, prices and wages become flexible. The economy adjusts to new conditions through changes like shifting resources or re-allocating labor. This leads to a new equilibrium where output returns to its natural level. The long-run aggregate supply curve (LRAS) is vertical, indicating that Real GDP is determined by factors like technology and resources, not price level.

Understanding these differences is essential to comprehend how policy changes or economic shocks affect the economy differently over time.

Real GDP

Real GDP, or Real Gross Domestic Product, measures the total value of all goods and services produced in an economy during a specified period, adjusted for inflation. This measurement reflects the economy's true productive capacity, removing the effects of price level changes.

In the aggregate demand and supply framework, real GDP is shown on the horizontal axis and is critical in understanding economic health. At equilibrium E0, the real GDP is Y0, representing the economy's output at that point.

When aggregate demand shifts left, real GDP decreases to a new level, Y1, in the short run, indicating lower economic activity. Over time, if the economy adjusts, real GDP may move back towards its potential level. Real GDP thus serves as an indicator of the economy's performance and potential output.

Price Level

Price level represents the average of current prices across the entire spectrum of goods and services produced in the economy. In an aggregate demand and supply diagram, it's represented on the vertical axis.

At the initial equilibrium, the price level is P0, which balances the economy's aggregate demand and supply. A fall in aggregate demand results in a lower price level P1 in the short run due to decreased demand for goods and services.

The price level can inform us about inflation or deflation trends. In the long run, prices adjust based on broader economic changes. The economy may see a new stable price level depending on how supply responds to demand shifts. Understanding price levels helps in assessing purchasing power and economic stability.