Question

Assume that (a) the price level is flexible upward but not downward and (b) the economy is currently operating at its full-employment output. Other things equal, how will each of the following affect the equilibrium price level and equilibrium level of real output in the short run? a. An increase in aggregate demand. b. A decrease in aggregate supply, with no change in aggregate demand. c. Equal increases in aggregate demand and aggregate supply. d. A decrease in aggregate demand. e. An increase in aggregate demand that exceeds an increase in aggregate supply.

Short answer

In each scenario, If AD increases further than AS, price level rises with potential inflation. If AD decreases, output decreases due to sticky prices. If AS decreases, price level rises with reduced output.

Step-by-step solution

Understanding Full Employment Output

At full-employment output, the economy is producing at its maximum sustainable output level without causing inflation. This is often referred to as the long-run aggregate supply (LRAS), and it is vertical because it represents an output level that does not change with the price level.

Scenario A: Increase in Aggregate Demand

With an increase in aggregate demand (AD), the AD curve shifts to the right. Since the price level is flexible upwards but not downwards, the price level will rise to restore equilibrium at the new AD level, but output will remain at full-employment levels temporarily in the short run, creating an output gap with actual output.

Scenario B: Decrease in Aggregate Supply

A decrease in aggregate supply (AS) shifts the AS curve to the left. As supply decreases, fewer goods are available at the existing price, pushing the price level upward while the level of real output declines because resources are not being used as efficiently.

Scenario C: Equal Increases in Aggregate Demand and Supply

If both aggregate demand and aggregate supply increase equally, both curves shift rightward by the same amount. This results in a higher equilibrium level of real output, while the price level remains the same in the short run since the increases cancel each other out in terms of price impact.

Scenario D: Decrease in Aggregate Demand

A decrease in aggregate demand shifts the AD curve to the left. However, since the price level cannot move downwards, the equilibrium price level remains unchanged with a temporary oversupply, which affects output downward in terms of employment and resource utilization.

Scenario E: AD Increase Exceeding AS Increase

When aggregate demand increases more than aggregate supply, both the AD and AS curves shift rightward with AD shifting more. The price level rises due to increased demand, while real output also increases. However, because the price level is upward flexible, inflation could occur if demand continually outpaces supply.

Key concepts

Full-Employment Output

Full-employment output refers to the level of output that an economy can sustain over the long term without generating inflation. It represents the level of output produced when all available productive resources are being used efficiently.
At this point, the economy is neither in a boom nor in a recession, and unemployment is at the natural rate.
This concept is important as it serves as an anchor for understanding potential output. It is often depicted as a vertical line on a graph, illustrating that output at this level does not fluctuate with changes in the price level. This vertical line is known as the Long-Run Aggregate Supply (LRAS) curve.
By focusing on full-employment output, policymakers aim to optimize resource allocation and stabilize the economy.

Price Level Flexibility

Price level flexibility refers to how easily prices can adjust in response to changes in the economy. In many scenarios, prices can move upward with ease but may not readily decline.
This characteristic of 'sticky downward prices' often occurs due to factors such as wage contracts, menu costs, and the desire of companies to avoid reducing salaries or prices, which can lead to unhealthy competition.
In the current context, with prices being flexible upwards but not downwards, an increase in demand often causes a rise in prices rather than an increase in output. On the other hand, if demand decreases, the price might remain stagnant, leading to excess supply as the price cannot fall to the new equilibrium level. Consequently, price flexibility plays a crucial role in determining how the economy adjusts to changes in demand and supply.

Equilibrium Real Output

Equilibrium real output is the point where the economy's supply and demand meet at a particular price level. This equilibrium is achieved when there is no excess supply or demand in the market.
It is essential to differentiate between short-term and long-term equilibrium levels. The long-term equilibrium is aligned with the full-employment output, while in the short run, various factors can create fluctuations. When aggregate demand or supply shifts, the equilibrium real output may temporarily deviate from full-employment output. However, adjustments typically move it back towards the natural level over time, assuming no intervention.
Understanding equilibrium real output assists in assessing the economy's position and potential output gaps.

Aggregate Demand Curve

The aggregate demand curve represents the total quantity of goods and services demanded across all levels of the economy at different price levels. It usually slopes downwards, indicating that higher price levels lead to a reduced quantity demanded.
A few key factors can influence shifts in the aggregate demand curve:

• Changes in consumer spending, often influenced by income and confidence levels.
• Variations in investment spending due to interest rates and business sentiment.
• Alterations in government spending and fiscal policy.
• Exports and import levels affected by exchange rates and global economic conditions.

An increase in aggregate demand will shift the curve to the right, potentially raising both the price level and real output, provided other factors remain constant. Conversely, a decrease shifts the curve to the left, often reducing output and price levels in a flexible price environment.

Aggregate Supply Curve

The aggregate supply curve illustrates the total output producers are willing to supply at various price levels. It includes both short-run and long-run perspectives, with different slopes for each.
In the short run, the curve is typically upward-sloping, indicating that as price levels rise, producers are encouraged to supply more. However, in the long run, the aggregate supply curve is vertical, consistent with full-employment output. Various factors can cause shifts in the aggregate supply curve:

• Resource availability and costs, including labor and raw materials.
• Technological advances that improve production efficiency.
• Government regulations and taxes that impact production costs.

Understanding how the supply curve behaves in response to changes helps in anticipating potential economic scenarios and policy impacts, crucial for both short-term adjustment and long-term economic planning.