Question

Suppose that AD and AS intersect at an output level that is higher than the full-employment output level. After the economy adjusts back to equilibrium in the long run, the price level will be ____ . a. Higher than it is now. b. Lower than it is now. c. The same as it is now.

Short answer

a. Higher than it is now.

Step-by-step solution

Understand Key Concepts

AD stands for Aggregate Demand and AS stands for Aggregate Supply. The intersection of AD and AS determines the equilibrium output and price level in the economy. Full-employment output refers to the level of output where all available resources are being used efficiently without causing inflation.

Interpret the Initial Scenario

In this scenario, the intersection of AD and AS is at an output level higher than full-employment output. This indicates that the economy is producing beyond its sustainable capacity, leading to an inflationary gap.

Predict Economic Adjustments in the Long Run

In the long run, an economy with an output level higher than full employment will typically see an upward pressure on wages and prices as resources become scarce. Workers demand higher wages, and firms increase prices to cover higher costs.

Determine the Effect on Price Level

As firms increase prices due to higher costs and increased demand, the aggregate price level in the economy rises. This adjustment continues until the aggregate supply decreases due to increased production costs, lowering the output back to full-employment level.

Choose the Correct Option

After understanding that the price level increases as the economy adjusts back to its long-run equilibrium at full employment, the correct answer is that the price level will be higher than it is now.

Key concepts

Aggregate Demand

Aggregate Demand (AD) represents the total demand for goods and services in an economy. It encompasses everything that households, businesses, governments, and other countries want to purchase within a specific period. Think of it as the heartbeat of economic activity, driving production, employment, and growth.

• **Components**: AD consists of four key components: - Consumption spending by households. - Investment spending by businesses. - Government spending on goods and services. - Net exports, which is the value of a country’s exports minus its imports.
• **Factors Affecting AD**: Many factors can shift the AD curve. Some prominent factors include changes in taxation, interest rates, consumer expectations, and foreign exchange rates.

Understanding how these components interact helps determine the overall demand in the economy, and shifts in AD can lead to different economic scenarios like inflationary or recessionary gaps.

Aggregate Supply

Aggregate Supply (AS) shows the total quantity of goods and services that producers in an economy are willing and able to supply at a given price level. It provides a snapshot of how much is produced across the economy.

• **Short-Run vs Long-Run**: The AS curve looks different in the short run compared to the long run. Short-run AS can be influenced by temporary factors, while long-run AS is determined by the availability of resources, technology, and policies.
• **Factors Influencing AS**: Key influencers include input prices, productivity levels, government regulations, and technological advancements.
• **Role in Equilibrium**: When AD intersects AS, it determines the market equilibrium, which affects the overall output and price level in the economy.

By observing the shifts in the AS curve, economists and policymakers can gauge aspects like productivity and how responsive the economy might be to changes in demand.

Full-employment Output

Full-employment output is a crucial concept in economics. It is the level of output that an economy can produce when all resources are utilized efficiently. In this context, 'full employment' doesn't mean every individual is working. Instead, it refers to a situation where there is only natural unemployment, such as frictional and structural unemployment.

• **Characteristics**: At full-employment output, an economy operates at its potential without inflationary pressures. Businesses are operating at full capacity, and workers are employed in the most productive way.
• **Importance**: Reaching full-employment output suggests optimal use of resources, minimal waste, and balanced economic growth. It represents the sustainable level at which an economy can operate without causing inflation.

Achieving full-employment output is a major goal for policymakers as it signifies a stable and efficient economy poised for steady growth.

Inflationary Gap

An inflationary gap occurs when the actual output of an economy exceeds its potential or full-employment output. It's like an economy running hotter than it should, leading to upward pressure on prices.

• **Causes**: This can happen due to high consumer demand, expansive fiscal policies, or low interest rates fueling more investment than the economy can handle at its current potential.
• **Consequences**: An inflationary gap often results in increased inflation rates because demand surpasses the capacity to supply. As more money chases a limited number of goods, prices tend to rise.
• **Adjustment Process**: In response, the economy will typically see rising wages and prices. Over time, these increased costs may lead to a reduction in supply as businesses find it more expensive to produce, which can then bring the economy back to its full-employment output level.

The inflationary gap is a warning signal that the economy cannot sustain its current output level without prompting a rise in inflation.