Question

Along the classical or vertical range of the aggregate supply curve, a decrease in the aggregate demand curve will decrease a. both the price level and real GDP. b. only real GDP. c. only the price level. d. neither real GDP nor the price level.

Short answer

When the aggregate demand curve decreases in the classical or vertical range of the aggregate supply curve, it results in a lower equilibrium price level. However, real GDP remains unchanged as the vertical aggregate supply curve implies the economy is operating at full capacity. Therefore, a decrease in aggregate demand will only decrease the price level. The correct answer is c. only the price level.

Step-by-step solution

Aggregate Supply and Aggregate Demand

Aggregate Supply (AS) curve represents the total supply of goods and services that are produced in an economy at a given overall price level. It shows the relationship between the national output (real GDP) and the price level. Aggregate Demand (AD) curve represents the total demand for goods and services in an economy at different price levels. It shows the relationship between the quantity of output demanded at different price levels. #Step 2: Identify the scenario#

Classical or vertical range of the aggregate supply curve

In the classical range, the aggregate supply curve is vertical, implying that any change in the aggregate demand curve will have no effect on real GDP and will only affect the price level. This occurs because, in the classical range, the economy is presumed to be operating at its full capacity, and therefore any increase or decrease in demand cannot lead to a change in the total output. #Step 3: Visualize the interaction#

Interaction between Aggregate Supply and Aggregate Demand curves

In order to understand the impact of a decrease in aggregate demand on price level and real GDP, we need to visualize the interaction between the vertical aggregate supply curve and the aggregate demand curve. When the AD curve decreases (shifting to the left), it meets the AS curve at a point where the price level is lower, leading to a lower equilibrium price level. #Step 4: Analyzing the impact on price level and real GDP#

Decrease in aggregate demand

As the aggregate demand curve shifts to the left, it intersects with the vertical AS curve at a lower point, which leads to a lower price level. However, as the AS curve is vertical (no change in real GDP), a decrease in aggregate demand doesn't affect the output. Based on this analysis, the correct answer is: c. only the price level.

Key concepts

Aggregate Supply Curve

Understanding the aggregate supply curve is crucial as it depicts the total supply of goods and services that producers are willing to create and sell at various price levels. It's a graphic representation that plays a pivotal role in the analysis of macroeconomics.

Imagine a graph where the vertical axis represents the price level and the horizontal axis signifies the real GDP, which is the output of an economy adjusted for inflation. As the price level rises, producers are typically willing to supply more, reflecting a positive relationship between the price level and the quantity of goods and services supplied. This relationship is shown by an upward sloping aggregate supply curve.

However, it's important to note that the aggregate supply curve can shift based on several factors, such as changes in the costs of production, technological advancements, and alterations in the availability of labor or capital. These shifts represent changes in the economy's potential to produce goods and services at all price levels. When the aggregate supply curve shifts, it can have significant implications for economic performance and policy.

Aggregate Demand Curve

The aggregate demand curve represents the total demand for goods and services in an economy at various price levels. It is an essential concept in understanding the behavior of economies. Unlike the aggregate supply curve, the aggregate demand curve typically slopes downward.

This downward slope indicates that as the price level falls, the quantity of goods and services demanded increases. This inverse relationship can be attributed to several reasons, such as the wealth effect, where consumers feel wealthier when prices are lower and, therefore, spend more. There's also the interest rate effect: lower prices lead to lower interest rates, which encourages borrowing and spending.

Keynesian economics suggests that aggregate demand is influenced by factors such as government spending, consumer spending, investment by businesses, and net exports. A shift in the aggregate demand curve can occur due to changes in these components, leading to a different equilibrium of price level and output in the economy.

Classical Range of Aggregate Supply

Diving deeper into macroeconomic theory, the classical range of aggregate supply is a segment where the aggregate supply curve is perfectly vertical. This is significant because it designates a level of output where the economy is said to be at full employment or full capacity.

In this scenario, all available resources are being utilized efficiently, and no additional output can be produced, regardless of changes in the price level. Hence, within this classical range, even if there is a fluctuation in the aggregate demand, the real GDP remains constant because the economy's output is at its maximum potential.

This concept is integral in classical economics, which posits that in the long run, economies tend to operate at full capacity, with resources fully employed. Any deviations from this point, caused by changes in aggregate demand, will only lead to changes in the price level – not output – thus highlighting the importance of supply-side policies for long-term economic growth.

Real GDP

Real GDP, or Gross Domestic Product adjusted for inflation, is a fundamental measure that reflects the total economic output of a country. It accounts for all the goods and services produced over a specified time period, usually a year or a quarter, adjusted to remove the effects of price changes.

Real GDP differs from nominal GDP, which measures economic output using current prices and does not adjust for inflation. By using constant prices, real GDP provides a more accurate depiction of an economy's size and how it's growing or contracting over time.

Importantly, real GDP is used to compare the productivity and living standards between different years or countries. Growth in real GDP is one of the primary goals of economic policy, as it indicates an increase in the economic well-being of a country. Economists and policymakers closely monitor changes in real GDP to make informed decisions about fiscal and monetary policies.