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.