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

(a) Price level rises; output unchanged. (b) Price rises; output falls. (c) Price stable; output rises. (d) Output falls; price stable. (e) Price rises; output rises.

Step-by-step solution

Understanding the Scenario

The economy is currently at full employment. This means the economy is operating at its maximum sustainable output level. Prices are flexible upward but not downward, so if demand increases, prices can increase, but they will not decrease if demand falls.

Analyze Increase in Aggregate Demand (a)

When aggregate demand increases in a full-employment economy, output cannot increase because resources are fully employed. Hence, the excess demand will lead to an increase in the price level while real output remains unchanged.

Analyze Decrease in Aggregate Supply (b)

A decrease in aggregate supply, with no change in demand, results in a higher price level and a reduced real output because less output can be produced at any given price, thus leading to a supply shock.

Equal Increases in Aggregate Demand and Supply (c)

Simultaneous and equal increases in both aggregate demand and supply will generally increase the real output while keeping the price level relatively stable since the effects offset each other in terms of price changes but increase real output.

Analyze Decrease in Aggregate Demand (d)

With price levels being rigid downward, when aggregate demand decreases in a full employment context, the real output will decrease without a change in the price level, leading to unemployment and underutilization of resources.

Increase in Demand Exceeding Supply Increase (e)

If the increase in aggregate demand exceeds the increase in aggregate supply, you will see an increase in the price level because the demand-driven price effect dominates the supply effect, while real output will increase due to the rise in production capacity.

Key concepts

Aggregate Demand

Aggregate demand refers to the total quantity of goods and services demanded across all levels of an economy at a given overall price level and in a given period. It's a critical concept in macroeconomics, influencing key economic outcomes such as employment, inflation, and production.

Understanding aggregate demand helps us analyze how changes in pricing or economic conditions can impact the overall economy. For instance, when aggregate demand increases, consumers and businesses want to purchase more goods and services at the current price, potentially leading to higher price levels if the supply does not match this increased demand.

• Components: Aggregate demand consists of consumption, investment, government spending, and net exports.
• Impact: Changes in aggregate demand can affect employment levels and inflation rates.
• Link to Price Level: When demand rises, it often leads to higher price levels, especially if supply remains constant.

In a full-employment scenario, an increase in aggregate demand typically leads to higher prices since the economy is already operating at its maximum capacity.

Aggregate Supply

Aggregate supply represents the total supply of goods and services that firms in an economy plan to sell during a specific time period. It's crucial for determining the productive capacity of the economy. Aggregate supply is dependent on factors like labor force size, technological advancements, and resource availability.

Contrast to demand, aggregate supply can be influenced by the ability of the economy to produce goods and services. If aggregate supply decreases, it indicates that fewer goods and services are available at the prevailing prices, leading to inflationary pressures when demand remains constant.

• Short-run vs. Long-run: In the short run, prices are sticky and do not adjust immediately to changes in demand or supply. In the long-run, prices are more flexible.
• Determinants: Factors such as wages, resource prices, and government regulations can shift supply.
• Effect of Supply Shock: A supply shock can lead to higher prices and reduced outputs.

Thus, an economy at full employment facing a decrease in aggregate supply will experience a rise in the price level due to reduced production capacity.

Equilibrium Price Level

The equilibrium price level is where aggregate demand equals aggregate supply, meaning there's no tendency for the price level to change. It’s the point where the economy’s output is at its optimum, balancing the desires of consumers and producers.

At equilibrium, the amount of goods consumers want to buy equals what producers want to sell, thus stabilizing prices. Changes in either demand or supply can shift this balance, affecting the equilibrium price level.

• Price Flexibility: Upward price flexibility means prices can adjust upwards if demand increases, preventing shortages.
• Supply and Demand Balance: If aggregate demand increases in a full-employment economy, the equilibrium price will rise since real output is fixed.

Understanding the equilibrium price level helps analyze how various economic factors impact inflation and purchasing power in both short and long-term scenarios.

Full Employment

Full employment is when all available labor resources are being used in the most economically efficient way. It doesn't mean zero unemployment but rather a situation where only frictional (short-term job changes) and structural (mismatch of skills) unemployment exist.

An economy at full employment is producing at its potential output, and any increase in aggregate demand will typically lead to inflation rather than increased output, as the labor force and resources are fully utilized.

• Characteristics: Full employment reflects the maximum output level when the economy is using its labor and resources efficiently.
• Implications: Increases in demand can lead to inflation without corresponding increases in output.
• Challenges: Political and economic policies aim to keep unemployment low without causing runaway inflation.

Therefore, in the context of the exercise, regardless of demand increases, output remains constant, highlighting the inflationary pressures at full employment.

Real Output

Real output is the total value of goods and services produced in an economy, adjusted for inflation, thus providing a clearer picture of economic growth. Unlike nominal output, real output reflects true productivity growth as it discounts the effects of changing price levels.

In macroeconomics, real output is a central focus since it indicates the economic well-being of a country. At full employment, the real output is at its highest sustainable level.

• Measuring Growth: Real GDP is often used as a measure of real output, indicating the economic health of a country.
• Inflation Adjustment: Adjusting for inflation allows for comparisons over different time periods.
• Impact on Policy: Policymakers use changes in real output to decide on fiscal and monetary policies.

In the scenario described, even with demand changes, real output stays constant in a full-employment economy, yet price levels may fluctuate, illustrating inflation dynamics.