Question

Suppose that an economy begins in long-run equilibrium before the price level and real GDP both decline simultaneously. If those changes were caused by only one curve shifting, then those changes are best explained as the result of: a. The AD curve shifting right. b. The AS curve shifting right. c. The AD curve shifting left. d. The AS curve shifting left.

Short answer

The changes are best explained by the AD curve shifting left (option c).

Step-by-step solution

Understand the Economic Equilibrium

In a long-run economic equilibrium, the aggregate demand (AD) and aggregate supply (AS) curves intersect at a point where the economy is producing at its full potential, termed as full-employment output. This also implies stable price levels and GDP.

Analyze Change in Price Level and GDP

The problem states that both the price level and real GDP decline. This implies that the changes are due to a shift in either the AD curve or the AS curve. We need to identify which curve's shift can cause both of these reductions.

Effects of AD Curve Shift on Economy

If the AD curve shifts to the right, the price level and GDP would increase due to greater demand. Conversely, if it shifts to the left, the price level and GDP would decrease due to a reduction in demand for goods and services.

Effects of AS Curve Shift on Economy

If the AS curve shifts to the right, this usually results in a decrease in the price level with an increase in real GDP as supply expands. Alternatively, if it shifts to the left, both price level and GDP would increase due to decreased supply, causing inflation.

Determine Which Shift Matches the Scenario

A leftward shift of the AD curve leads to both a decrease in price level and GDP, matching the stated conditions: simultaneous decline of price level and GDP.

Key concepts

Economic Equilibrium

Economic equilibrium in the context of an economy involves the intersection of both the Aggregate Demand (AD) and Aggregate Supply (AS) curves at a point where the economy produces at its full potential. This ideal state is referred to as full-employment output.
When an economy is in equilibrium, it essentially means that all available resources are being fully utilized. Consequently, the output of goods and services is at a sustainable level, with neither excess supply nor inadequate demand.
This balanced state leads to a stable price level. Since all sectors of the economy are in sync, there's typically no upward or downward pressure on the overall price level. Simultaneously, Gross Domestic Product (GDP), which measures the total economic output, remains steady, signifying economic health.

Aggregate Demand (AD) Curve

The Aggregate Demand (AD) Curve is a crucial concept that represents the total quantity of goods and services demanded across all levels of an economy, at various price levels. It's typically depicted as a downward-sloping curve on an AD-AS graph.
The downward slope is due primarily to three effects:

• Real Balances Effect: When the price level falls, the purchasing power of money increases, allowing consumers to buy more.
• Interest Rate Effect: Lower price levels lead to lower interest rates, encouraging more investment and spending.
• Net Export Effect: A decrease in price level can make domestic goods cheaper relative to foreign goods, enhancing exports.

Thus, shifts in the AD curve are indicative of changes in overall economic demand. For instance, a rightward shift signals an increase in demand, leading to higher GDP and price levels. Conversely, a leftward shift, like the one described in the exercise, results in decreased demand, thus lowering GDP and price levels.

Aggregate Supply (AS) Curve

The Aggregate Supply (AS) Curve depicts the total production of goods and services that firms in an economy plan to sell at different price levels. It's upward sloping due to the positive relationship between the price level and the amount of output firms are willing to produce.
Within this framework, the AS curve can shift based on several factors:

• Changes in Resource Prices: A rise in input prices shifts AS left, while a decrease shifts it right.
• Technological Advances: Innovations can increase productivity, shifting AS to the right.
• Policy Changes: Policies like taxes or subsidies can also influence AS shifts.

In the exercise scenario, a shift in the AS curve to the right generally lowers prices while boosting GDP, due to increased output from more accessible supply. If shifted left, it typically raises prices and decreases GDP, which contrasts with the exercise scenario where both GDP and price levels fall.

Long-Run Equilibrium

Long-run equilibrium extends the concept of economic equilibrium to a time horizon where all resources and inputs are fully adjustable, allowing the economy to reach its full productive potential.
At this stage, both the AD and AS curves intersect at full employment output, but prices are flexible, meaning they can adjust without constraints. In this scenario, there is neither a tendency for inflation nor deflation, barring any external shocks.
When an economy is in long-run equilibrium,

• Everyone who wants to work (at the prevailing wage rate) is employed, showcasing full employment.
• There's no excessive or deficient demand; hence, the price level remains stable.

If changes like technological breakthroughs or major policy shifts occur,
They can impact long-run equilibrium by altering the productive capacity of the economy, leading to a shift in the AS curve, but not necessarily affecting the current price level or GDP unless the AD curve also shifts.